Derivatives are financial investments that derive their value from another underlying asset. This means that a derivative’s price is closely tied to that of the security it is based on. For instance, the value of an option on the Standard & Poor’s 500 index will fluctuate with the price of the S&P 500 index.
Because a derivative’s price is closely tied to that of the underlying asset, derivatives make good hedging vehicles, says Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management in Horsham, Pennsylvania.
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For instance, an investor who owns 100 shares of the S&P 500 index may wish to minimize the risk that the price of the S&P 500 falls. To do this, he could purchase a put option, which would give him the right to sell 100 shares of the S&P 500 index at a preset price, called the strike price. No matter how low the S&P 500 falls before the option expires, he will always be able to sell his shares for the strike price. In this way, he has hedged his position by protecting himself from loss below the strike price of the put.
Depending on how they are used, derivatives can either increase or decrease the amount of risk in your portfolio, says Bard Malovany, a certified financial planner and principal at Aspect Partners in Fairfax, Virginia. When you purchase a put for an asset you own, called a protective put, as in the example above, you are decreasing the risk in your portfolio. As you already hold the underlying asset, the only potential downside to your derivative position is the cost of the premium you paid for the option.
If you were to sell a call option, however, you would be giving someone else the right to buy the underlying security from you at the strike price. If you sold a call option on a position you did not own, this could mean you’d be forced to go out and buy that security for a higher price in the market so you can sell it to the holder of the call option at the strike price. In this case, you have unlimited risk because the underlying security could rise to any price and you would still have to purchase it to resell it at the lower strike price. What’s more, you would have to purchase not just one share of the underlying security, but 100 shares to fulfill your obligation to the contract holder.
Weapons of mass destruction or mass protection. Derivatives have gotten a bad name in the press because people often “don’t understand the implied leverage in a derivative,” says John Culbertson, chief investment officer of Context Capital Partners in Bala Cynwyd, Pennsylvania.
This is especially true with a futures contract, which can give investors huge leverage over an underlying security. For instance, the S&P 500 future currently trades at a value of 50 to 1, meaning each dollar of the futures contract is worth $50 of the S&P 500 index. At more than $2,600 per contract, each S&P 500 futures contract controls more than $130,000 worth of the S&P 500 index.
That leverage can work to an investor’s advantage: If you want to gain $130,000 of S&P 500 exposure, all you need to do is pay $2,600 to buy one S&P 500 futures contract. However, if the index drops 2 percent, or $2,600, you have essentially lost everything. “Leverage works both ways: When it goes your way, it’s wonderful; when it doesn’t, it’s problematic,” Culbertson says.
That’s why retail investors had better understand the leverage implied in any derivative strategy before using it. “People have made or lost a lot of money on derivatives because they are so leveraged,” Ren says. Warren Buffett has even called derivatives financial weapons of mass destruction because of their high leverage.
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The safest way to use derivatives as a hedge in your portfolio is to never let your derivative exposure exceed the value of the underlying asset in your portfolio, Ren says. For instance, if you hold $10,000 of the S&P 500, don’t sell $15,000 of S&P 500 futures because this would put you at risk of losing more than you hold.
Managing your exposure is especially important when trading futures because their prices can swing widely on a daily basis, Ren says. Investors should be monitoring their derivatives exposure continually to ensure they never exceed their threshold. “Derivatives are not a buy-and-hold [strategy],” he says. If the value of your derivatives position rises sharply, you should trim your exposure by realizing some of your gains.
Use smaller contracts with tight bid-ask spreads. E-mini futures contracts are popular among retail investors because they represent only a fraction of a standard futures contract, says Jean Folger, managing partner at PowerZone Trading in Bryson City, North Carolina. For example, e-mini S&P 500 futures are one-fifth the size of the standard S&P 500 futures. This enables investors to access the futures market at lower costs and tighter bid-ask spreads. The bid-ask spread is the difference between the price traders are asking for the asset and the price they are offering to buy it for.
When investing in derivatives, look for contracts with high daily trading volume and tight bid-ask spreads because they are more liquid. “With the e-minis, traders are usually looking for a spread of one to two ticks — that signals there’s enough liquidity to get out of the trade quickly,” Folger says. The tick size varies depending on the contract you are trading. For e-mini S&P 500 futures, the tick size is 0.25.
E-mini futures still carry the same risks of standard futures contracts, and as with all derivatives, make sure you understand the product before investing. “Derivatives may be appropriate for any investor who wants to hedge a position, provided they’ve done their homework, understand how derivatives work and are comfortable with the risks,” Folger says.
[See: The Fastest Ways to Lose All Your Money in the Stock Market.]
There’s an old saying in poker: If you look around the table and you don’t know who the sucker is, you’re the sucker, Malovany says. If you’re a retail investor trading derivatives without knowing what you’re doing, and “you feel like you’re getting a good deal, you’re probably the sucker.”
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Minimize Risk by Hedging With Derivatives originally appeared on usnews.com
