Portfolio Risk Management with Derivatives

In the previous chapter on Leverage and Payoff, we discussed how leverage amplifies the potential returns and risks in derivative trading. Let's look at using derivatives to manage and hedge against risk in your investment portfolio, which shall help you manage market volatility.

There is a risk in investing, but the way you manage that risk will determine your success. Derivatives could be a key factor for investors in portfolio risk management by providing ways to hedge against the volatility of markets while attempting to achieve returns.

What is a Derivative?

In simple terms, the derivatives are financial contracts whose values are derived from the underlying asset, which may be a stock, commodity, or indices. They come in different versions like futures, options, and swaps. They enable an investor to speculate on the movement of the prices without necessarily holding an actual asset, but it can be used to hedge the risks.

Why use derivatives for portfolio risk management?

By incorporating derivatives into your portfolio, you can hedge against adverse market movements and protect your investments.

1. Hedging Against Market Downturns

The main use of derivatives in portfolio risk management is hedging. Hedging involves taking a position in a derivative that offsets the risk in your main investments. For instance, if you are heavily invested in stocks, you hedge with Nifty futures or options. In case the market falls, your derivative position will increase in value to partly offset the losses in your equity portfolio.

Assuming a 5% fall in Nifty Index would present a loss in the equity portfolio, a shortsided hedge position in Nifty futures or buying put options can prevent the loss.

2. Protection against fluctuations in currency

Investors with international exposure, or investors in foreign stocks, do carry substantial currency risks. The volatility in the Indian rupee impacts the value of their investments abroad. Here derivatives on currencies like forwards or futures will help in hedging that risk. You lock in an exchange rate well in advance to cushion your portfolio from adverse movements in the values of currencies.

3. Reduction of Stock-Specific Risk

If you have a big position in one stock, that means it's certain that it involves risks, such as poor earnings reports or regulatory changes. This is the stock specific risk that options can reduce. You could use a protective put, wherein you buy a put option against stock you already own, to give you downside protection in case the stock suddenly falls. This will let you limit your losses while retaining potential for gains if the stock appreciates.

4. Enhancing Returns with Covered Calls

Other portfolio risk management approaches include the covered call strategy, whereby one sells calls of stocks that one already owns. In using this strategy, premiums collected from the sale of these calls add to a sort of income that may buffer the volatility of your portfolio. However, this comes with the disadvantage that your upside potential will become capped if the stock's rise goes beyond the options' strike price.

Conclusion

Derivatives represent some of the powerful tools that hedge portfolio risks in the market, mitigating market downtrends, currency fluctuations, and events occurring in specific stocks. By incorporating derivatives into your investment strategy, you can better protect your portfolio while continuing to pursue growth. Now in the next chapter, we’ll dive into volatility and its impact on derivatives, exploring how market fluctuations influence derivative prices and how you can leverage this for better risk management.