We all have that friend who won’t invest in anything, ever. They simply refuse to put their capital to work because doing that inherently carries risk. They think they’re market neutral and assume no risks by doing that.

But that’s a trap. They do have a position in the market; one always does. In this case, they’re long cash, which at this rate is losing at least 7.5% in purchasing power yearly.

Plus, unless they’re piling stacks of cash under their mattress, they’re keeping their money with a bank. Technically they’re lending it, and if the bank goes bust, their deposit is gone.

Everybody is a trader. Even if you make a trade once in a year or don’t make one at all. You’re juggling between different risks either way, so why not use trading tools available to you? Just because you saw others getting burned using them?

Contrary to popular opinion, investing doesn’t boil down to only buying and holding assets. We have an assortment of financial instruments to limit your portfolio risks or maximize returns. These are called derivatives.

Derivatives are financial contracts between two or more parties that derive their value from an underlying asset or group of assets. Typical underlying assets include stocks, bonds, commodities, interest rates, indexes, even cryptocurrencies.

In other words, you’re trading something that depends on the underlying asset. So, you can think about derivatives as bets, such as: “I think BTC will go to $100,000 by the end of 2022.”

There are many different types of derivatives, but the most common ones you’ll encounter are futures and options.

Futures are binding financial agreements between two parties—a buyer and a seller—to buy or sell an underlying asset at a certain time in the future at a certain price.

Options are similar to futures but differ in that they offer the holders the right—but not the obligation—to buy or sell the underlying asset at a specific price on or before a certain future date.

Now the mere mention of derivatives is enough to strike fear into many people’s hearts, mostly because they’re often associated with irresponsible trading behavior and taking on outsized risks. This reputation is somewhat warranted but also largely exaggerated. Derivatives are just financial tools, and like any other tool, they produce positive results if used properly.

For example, you can use derivatives to reduce (or hedge) certain risks or take on leverage in a capital-efficient manner to improve portfolio performance.

If you understand and learn how to properly use them, derivatives can be a very powerful supplement to your portfolio. The keyword here is “supplement” because, unless you’re trading them professionally, that’s what derivatives should exclusively be used for.

Hedging and leveraging with derivatives

Okay, enough theory, let’s consider some practical examples.

Say you’re bullish on ETH, and you believe its price will go up from its current price of $3,000. You can do two things; either simply buy ETH at $3,000 and hope the price goes up, or buy a call option for $200 (I completely made this price up), which gives you the right but not the obligation to buy one ETH at $3,000 at any time in the following month.

Now let’s assume you were right, and ETH hit $4,000 in a month. You made a $1,000 profit or 33% on your initial $3,000 of capital invested in the first case. In the second case, if you exercised your call option, bought ETH at $3,000, and immediately sold it for $4,000, you made a $1,000 profit or 500% on your initial $200 of capital invested.

Now, suppose the trade went the opposite way, and ETH dropped to $2,000 in the following month. In the first scenario, you’d end up with $1,000 or 33% in realized or unrealized losses (depending on whether you sell). In the second scenario, you’d only lose the $200 you paid as premia to buy the call option contract or 100% of the capital you invested.

The derivative instrument, in this case, magnified your wins and losses in relative terms. Still, in absolute terms, you were able to use much less capital to make the same directional bet for the same nominal profit.

While it depends on how this move would fit in the context of your entire portfolio structure and investment strategy, this would generally be considered as taking on additional risk. But how do you use derivatives to hedge or reduce risk?

To hedge something with a derivative you simply make the opposite bet against the thing you already have exposure to.

Let’s assume your whole portfolio consists of 5 ETH, which at $3,000 apiece totals to $15,000. Now let’s suppose you’re uncomfortable with the volatility and the risk you’re taking by being all-in on ETH, but also unsure of ETH’s price in the near future and don’t want to sell any of it.

What you could do is buy put options for $1,000 (again, a random price), which give you the right to sell 5 ETH at the price of $3,000 apiece at any time in the following month. Now for the price of $1,000, you’ve basically bought insurance against your whole portfolio. No matter what the price of ETH falls to, you’ll be able to exercise your put options and sell your ETH for $3,000, meaning you’d only be down the $1,000 you paid as premia to buy the contracts.

On the other hand, if ETH hit $4,000, you wouldn’t exercise your puts but let them expire instead. In that case, your portfolio would be worth $19,000 instead of $20,000 (5 x $4,000) because you spent $1,000 on the put options as insurance.

These are only two simple examples of how you could use derivatives to take on leverage or hedge certain risks. As you might imagine, derivatives allow you to express all sorts of positions on the market and can be used in many different ways to optimize your investment strategies.

Their inner workings, how they’re priced, and the specific risks you take by utilizing them can often be super complex and may require some study, but it’s a time well spent for anyone looking to grow into a well-rounded investor.

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Disclosure: At the time of writing, the author held ETH and several other cryptocurrencies. Read our trading policy to see how SIMETRI protects its members against insider trading.