Derivatives (options, futures, swaps) are often misunderstood as speculation tools. In reality, they're protection instruments. A properly constructed derivatives strategy reduces portfolio volatility and protects against extreme losses. Understanding derivatives is essential for professional portfolio management.
Options Basics
Calls give the right to buy; puts give the right to sell. Buying puts on stocks you own creates downside protection. The put acts as insurance: if stocks crash, put values rise, offsetting losses. This protection has a cost: the put premium.
Call-put parity shows calls and puts are equivalent but opposite-direction bets. A synthetic long position combines a call purchase with a put sale. Understanding these relationships prevents overpaying for protection.
Hedging with Futures
Index futures allow hedging entire portfolios without selling individual stocks. A portfolio with high correlation to the S&P 500 can be hedged by shorting S&P 500 futures. This removes systematic risk while preserving alpha generation capability.
Basis risk is the key challenge. Perfect hedges are impossible if portfolio composition differs from hedge instrument. A tech-heavy portfolio isn't perfectly hedged by SPY futures. Accepting some basis risk is necessary for practical hedging.
Tail Risk Hedging
Out-of-the-money put options provide tail risk protection. For a small recurring cost, they protect against extreme losses. A 10% portfolio allocation to puts on indices provides peace of mind and enables staying invested in crises.
Dynamic hedging adjusts protection levels based on volatility. High volatility increases hedging costs, so protection is reduced. Low volatility makes protection cheap, so it's increased. This keeps hedging costs stable through cycles.
Rolling and Rebalancing
Hedging positions require maintenance. Positions that drift out-of-the-money need rolling to new strikes. Rebalancing hedges as portfolio composition changes keeps protection aligned with actual risk. Dynamic hedging requires discipline but improves risk-adjusted returns.
Educational content only. Not investment advice.