Investors are exposed to risk on a daily basis. Risk management is therefore required while trading in the financial markets. The solution to managing risk effectively lies within the use of financial derivatives.
A derivative may be understood as a financial instrument where its price is determined by the value of an underlying asset. It may be referred to a contract between two parties where one party has an obligation to buy or sell the underlying asset, while the other has the right to buy or sell the underlying asset.
Using derivatives to hedge risk
Hedging risk through derivatives is a popular option for many investors. This is done by hedging a position to gain protection against the risk of an adverse movement of an asset. Investors may, therefore, take an offset position in a related security, in order to reduce risks against adverse price movements.
There are numerous types of derivatives that may be used to lower risk. Following are three common derivatives that may be used for risk management.
Options refer to a contract between two parties where the buyer has the right and not the obligation, to buy the underlying asset on a specified date at a specified strike price. Options trading may be used by investors to protect themselves from the fluctuations in stock price, by allowing them to buy or sell the mentioned shares at a pre-determined price within a specific time- frame. You may employ various strategies to hedge risk through options such as covered calls or protective puts.
Futures trading refers to a financial contract between two parties, where the buyer or seller is obligated to buy or sell an asset respectively, at a pre-determined price on a pre-determined date. Some of the most common futures contracts are currency futures, index futures, stock futures, and commodities futures. Futures contracts give investors an idea of the future price of the value of an index or the price of a particular stock. It thereby allows hedgers to shift risk to speculators, thus enabling them to manage risks efficiently.
A forward contract is an agreement between the buyer and seller, wherein the seller agrees to provide the underlying commodity at a specific price to the buyer, at a future date. A forward contract may be used for hedging purposes as part of an investor’s risk management strategy. It minimizes risk, by reducing the profitability of an adverse fluctuation in the price of the said asset. Forward contracts are widely used by professional traders, individual investors, and institutional investors to control financial risks.
Derivatives have indeed proved to be an effective tool in risk management. It allows dealing with unwanted risk while allowing specific risk to be targeted efficiently. It is, however, important to understand derivatives well before using it as a risk-hedging instrument. If not fully understood, it may pose serious financial threats.