Derivatives are specialized investments that allow investors to benefit from the price move of some security or asset without actually owning the physical asset. Underlying securities can include but are not limited to stocks, bonds, and foreign currencies, and there are many different derivatives strategies that investors employ to benefit from these securities. The most common of all derivatives strategies is hedging, which allows an investor to cover one investment by contrasting it with its derivative. Options, which give the contract holder the right but not the obligation to buy or sell shares of an underlying security, and futures, in which the contract holder must buy the underlying security at some future date, are the two most common derivatives, and each have special strategies attached to them.
There are many different types of derivatives available to investors, allowing them the opportunity to become involved with multiple securities in a cost-effective and flexible way. Since that is the case, investors have a myriad of derivatives strategies from which to choose. Investors might be wise to focus on one or just a few to prevent themselves from overcomplicating the process.
Hedging is one of the most effective derivatives strategies available to investors. This strategy uses a derivative to contrast an investment security that an investor already owns. For example, an investor might buy heavily in a single stock. To protect against the loss that would occur if that stock's price falls, an investor can lock in a futures contract to sell the security on some future date at the current market price. In this way, the investor is covered no matter which way the price of the security moves.
It is important for investors holding options and futures contracts to realize that they have their own value separate from the value of the underlying security. For that reason, few investors actually exercise the derivatives contracts they hold, but instead choose to close out their options. One of the most common derivatives strategies, closing out an option allows a contract holder to benefit from the contract at its peak value by selling it to another buyer.
In the case of options, it is generally a safer strategy to be the contract buyer, which is also known as being in the long position. This is because the long position only has to pay the premium for the contract, with nothing more at risk. The seller in the short position, by contrast, runs the risk of losing significantly if the price of the underlying stock moves in the direction predicted by the buyer. For this reason, the short position investor should pay close attention to where he places the strike price, which is the price at which the contract becomes profitable and may be exercised by the buyer.