Use Cases

Investors typically use derivatives for three reasons—to hedge a position, to increase leverage, or to speculate on an asset's movement.

Hedging

Hedging a position is usually done to protect or insure against the adverse price movement risk of an asset. For example, the owner of a stock buys a put option on that stock to protect their portfolio against a decline in the price of the stock. In other words, they take opposite positions on the same security. The strategy is that if prices decline and they lose money on the stock, they will simultaneously make money on the put option (since the put should gain in value). This gain can offset the drop in the value of their stock.

On the other hand, if the stock price rises as hoped, the shareholder makes money on the appreciation in the value of the stock in their portfolio. However, they also lose money on the premium paid for the put option. A shareholder who hedges understands that they could make more money without paying for the insurance offered by a derivative if prices move favorably. However, if prices move against them, the hedge is in place to limit their loss.

Leverage

Derivatives can greatly increase leverage. For derivatives, leverage refers to the opportunity to control a sizable contract value with a relatively small amount of money. Leveraging through options works especially well in volatile markets. When the price of the underlying asset moves significantly and in a favorable direction, options magnify this movement.

Speculation

Investors also use derivatives to bet on the future price of the asset through speculation. Large speculative plays can be executed cheaply because options offer investors the ability to leverage their positions at a fraction of the cost of an equivalent amount of underlying asset.

Speculation can also expand to using derivatives to take directional bets on the underlying asset to generate income. One strategy for earning income with derivatives is selling options to collect premium amounts. Options often expire worthless, allowing the option seller to keep the entire premium amount. Although there is a decent opportunity for profit, selling options can entail a substantial amount of risk.