Derivatives are financial instruments, like options or futures, that allow investors to profit from the price move of an underlying security without actually gaining physical ownership of the security in question. Although they are relatively low-cost alternatives to buying stocks, derivatives can still carry a great deal of risk. One way to minimize derivatives risk is to use them to contrast other investments in a portfolio as a hedging strategy. It is also generally safe, in terms of options contracts, to be the buyer of the contract, as the seller runs the derivatives risk of having to pay off an unexpected, significant price move of the underlying security.
Many people think of investing only in terms of buying stock in a company, which gives investors actual, physical ownership in the company. The problem with this type of investment is that buying stock requires an investor to put up a significant amount of capital, and the investment usually takes a long time to become profitable. Derivatives are generally cheaper and more flexible, but they carry their own kinds of risk. Investors should know the realities of derivatives risk and the best ways to lessen it before getting involved.
The most common way of minimizing derivatives risk is by using derivatives as hedging instruments against other securities. Not only does this lessen the risk of the derivatives, but it also balances out the investment in the underlying security. For example, an investor might buy stock in a company and then buy an options contract that would benefit from the price of that stock falling. In this way, the investor is covered no matter which way the price of the stock moves.
With options contracts, one of the most common methods of derivatives investment, the best way to minimize derivatives risk is to be the contract holder. The person who buys the contract is said to be in the long position, while the seller of the contract is in the short position. While the buyer risks only the premium paid for the contract, which is usually just a fraction of the underlying security's price, the short position must sell the security to the buyer as is stipulated in the options contract. If the price moves significantly in the buyer's direction, the loss to the seller can be great.
One way for someone in the short position to mitigate derivatives risk is to select a futures contract as his derivative of choice. In a futures contract, the buyer has to commit to buying the security at a predetermined future date at the current market price. This allows the seller to lock in a price at which she is comfortable selling, while also allowing the seller potential for profit if the price of the underlying security drops before the sell date.