Derivatives are financial instruments that have values derived from other assets like stocks, bonds, or foreign exchange. Derivatives are sometimes used to hedge a position (protecting against the risk of an adverse move in an asset) or to speculate on future moves in the underlying instrument. Hedging is a form of risk management that is common in the stock market, where investors use derivatives to protect shares or even entire portfolios.

What Are Derivatives?

A derivative is a financial instrument with a price that depends on (or is derived from) another asset. It is typically a contractual agreement between two parties in which one party is obligated to buy or sell the underlying security and the other has the right to buy or sell the underlying security.

However, derivatives can take many forms and some—like OTC derivatives—are complex and mostly traded by professional rather than individual investors. On the other hand, many derivatives are listed on derivatives exchanges and are standardized in terms of the quantities traded (size), expiration dates, and exercise (strike) prices.

Equity options are examples of derivative contracts. A call option gives the owner the right (not the obligation) to buy 100 shares of stock per contract. A put option, on the other hand, is a contract that gives the holder the right to sell 100 shares of stock. Put options are often used to protect stock holdings or portfolios.

Example of Hedging

Hedging is the act of taking a position in a related and uncorrelated security, which helps to mitigate against opposite price movements. For example, assume an investor bought 1,000 shares of Tesla Motors (TSLA) for $65 a share. The investment is held for over two years and now the investor is worried that Tesla will miss earnings per share (EPS) and revenue expectations—sending shares lower and giving back some of the profits accumulated over those two years.

In April 2019, Tesla's stock price was $239—representing a value of $239,000 and an unrealized profit of $174,000 on 1,000 shares—and the investor wants to initiate a protective strategy. To hedge the position against the risk of any adverse price fluctuations, the investor buys 10 put option contracts on Tesla with a strike price of $230 and a September expiration date.

The put option contract gives the investor the right to sell his shares of Tesla for $230 a share through September. Since one stock option contract leverages 100 shares of the underlying stock, the investor could sell 1,000 (100 x 10) shares with 10 put options. This strategy—of buying shares and buying puts—is called the protective put.

Exercising Options

If Tesla misses its earnings expectations and the stock price falls below the $230 strike price, the investor has locked in a selling price of $230, through September, with the put option. The investor can sell the put after any increase in value or exercise the put: selling 1,000 shares at $230, gaining a profit of $165 ($230 - $65) per share. Once the put option is exercised (and a seller of the put has been assigned at $230 per share), the contract ceases to exist.

Of course, the put option was not free and the investor paid a premium to buy the protection. The premium paid reduces the net profits from exercising the contract. In the example, if each put costs $10, the net profit is $155 rather than $165 per share. On the other hand, if shares stay above $230 through the September expiration, the put will be worthless and the entire premium paid is lost, which is $10,000 on 10 contracts. Until then, the value of the put will change as time passes, and as the price of Tesla moves higher and lower.