Derivatives are actually a great portfolio tool. They can be used for trading, hedging, or speculation. Hedging though, is probably the key reason why you should add derivatives to the portfolio. There is lots of talk out there blaming derivatives for all sort of things, but used correctly derivatives definitely bring lots of value to your investment strategy.
Let's imagine you have an undesired position in the US equity market. In order to bring down this exposure (i.e. hedge it) you can trade US Equity futures (i.e. shorting equity futures derivatives contracts). In this way you end up bringing down your net equity risk until you decide to close off the derivative position (i.e. buying back the futures).
Trading is usually done as a way to get exposure towards a certain market or security, in a cheaper way.
Trading derivatives is usually a relatively easy thing to do but there are some derivatives that require more specialised skills, like exotic derivatives. The reason is understanding the market dynamics and nuances of the particular derivatives that you are trading and the ability to trade it via your broker/platform.
In case you are wondering to use derivatives make sure you understand the "why", the "what", and the "how", and if you still feel the quality of your answer is not great, then seek specialised help.
Speculation should be done with method and with extreme care as losses can severely impact your portfolio return in a big time.
Let's imagine you know that a certain stock is a steal at the price it is trading, so you might want to buy options on that stock and synthetically gain exposure to that stock price using very little of your capital (i.e. paying the option premium which is basically the cost of buying options). If let's say in 3 months time your assumption turns out to be correct, you can exercise the option and make a ton of money. I have left out lots of technical details but I hope you get the idea. Speculation with derivatives is like speculating in a traditional way (i.e. betting that something will go up/down) but with very little of your capital.
In short, if used correctly derivatives are a great addition, especially if your portfolio is at decent size (i.e. $1million+), but you can nonetheless use them even if your portfolio is small and want it to get to a decent size with a very lucky speculative derivatives position that turns out well (be very careful though)!
Comments