Understanding Derivatives: Risk Management Tools in Financial Markets

What are Derivatives?

Derivatives are financial instruments whose values are based on other assets, such as stocks, bonds, or commodity futures. They serve dual purposes: either hedging risk through protection agnst adverse price movements in the underlying asset or speculating on future price trs of that asset.

Hedging is a risk management strategy where an investor uses derivatives to mitigate potential losses from market fluctuations related to their existing holdings. As , imagine an investor who purchased 1,000 shares of Tesla at $65 each, expecting the investment's value to grow over time. Two years later, this same investor has amassed a portfolio worth $239,000 with an accumulated profit of $174,000. However, concerns about potentially missing earnings expectations and revenue forecasts from Tesla have emerged, which could s stock prices plummeting.

In April 2019 when Tesla's share price was at $239, representing a total portfolio value of $239,000 with an unrealized profit of $174,000 on those 1,000 shares, our investor is now worried about potential losses. To safeguard agnst any adverse movements in Tesla's stock price, the investor buys put optionsspecifically, a protective strategy called a put.

A Put Option at Work

A put option grants the holder the right but not the obligation to sell 100 shares of an underlying security at a pre-agreed price the strike price before the expiration date. In this scenario, our investor decides on buying a call option with a strike price set slightly below $239.

By purchasing these put options for each share they own, the investor is effectively securing the right to sell those shares at that predetermined price, no matter how low their market value might fall during the contract's duration. In essence, this puts a floor under the potential losses on the investment if Tesla's stock price declines.

While acquiring this protection comes with a premium costthe amount pd for buying each put optionour investor has managed to reduce potential losses should Tesla's share price decrease below $239 during the agreement period. However, if the stock price remns above $239 until expiration, the put options become worthless and the full premium pd $10 per contract would be lost.

Derivatives as Risk Minimization Tools

Derivatives serve as effective tools for risk management in financial markets by providing investors with strategies to hedge agnst potential losses. Through instruments like puts or calls, investors can protect their portfolios agnst market uncertntiesoffering peace of mind knowing they have a buffer agnst sudden drops in asset prices.

, while derivatives offer valuable protections and cost-effective solutions, they also involve risks associated with the underlying assets' performance and price movements. Investors should weigh these risks carefully before making decisions about derivative use.

SPONSORED

Engage with Crypto's Global Market

Join over 120 million registered users as you explore a world of secure transactions and low fees in cryptocurrency exchanges on Binance. Buy, trade, or hold Bitcoin, Ethereum, and more than 350 other popular cryptocurrencies, whether you're just starting out, an experienced trader, or a professional investor. Enjoy tools and guides that simplify of safely exchanging and managing NFTs with ease.

Partner Links

Explore Related Financial Concepts
This article is reproduced from: https://www.investopedia.com/ask/answers/052615/how-can-derivatives-be-used-risk-management.asp

Please indicate when reprinting from: https://www.ia44.com/Futures_and_Options/Derivatives_in_Finance_and_Hedging_strategies.html