Derivatives are simply investments that trade based on the price of something else. In other words, the price of a derivative is "derived" from something else.
Often that something else is an index, a stock or an exchange-traded fund (ETF). While derivatives can be customized and complex, there are also "plain vanilla" derivatives, and this variety includes ordinary call options and put options on stocks and ETFs.
An option is a derivative because the price of the option is based on the price of the underlying stock or ETF. Options give buyers the right to buy (in the case of a call option) or sell (with puts) a stock or ETF at a predetermined price (the strike price) before the option expires.
Options are typically used to leverage a move in an underlying stock or ETF, and they can potentially be used to provide portfolio insurance for individual investors.
In order to understand the costs and potential benefits of portfolio insurance, we will use an example.
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Imagine an investor with an account worth $10,000 invested entirely in the stock market. If the investor believes that stocks are likely to fall 10% or more in the next year, the investor could attempt to hedge with an ETF like the ProShares UltraShort S&P 500 (NYSE: SDS). This inverse ETF is leveraged to go up twice as much as the S&P 500 Index falls on any given day.
SDS is rebalanced daily, so it will not follow the index exactly over longer periods, but it has moved in the same general direction as the underlying index.
SDS is currently trading at about $33.35. Buying 100 shares of SDS would require $3,335 and would reduce the exposure to the stock market to $6,665. If the rest of the account rose 20% and SDS fell 40%, your total account value would be about $10,000, while an account without SDS would be worth $12,000. So, buying SDS would hurt your account in a bull market.
If stocks fell 20% and SDS rose 40%, your account balance would also be about $10,000.
Instead of buying SDS, you could buy a call option with a strike price of $30 expiring in January 2015 that is trading for about $5.90. Buying call options is generally thought of as a bullish strategy, but when you buy a call option on a leveraged inverse ETF like SDS, you are actually making a bearish bet and therefore hedging your portfolio.
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Buying one call option would cost you $590, because an option controls 100 shares of the underlying stock, leaving you $9,410 invested in stocks. In this scenario, if stocks rise 20%, the call would be worthless and your account would increase 12.9%. If stocks fell 20%, SDS should rise 40%, and the call option would show a gain of about 183%. Your overall account, however, would fall 8%.
Call options on SDS would offer some downside protection, but the amount is relatively small in this example, and the cost of owning SDS calls in a bull market is significant since it lowers your portfolio returns by about 7%.
If stocks rise or fall by 30%, the scenario is the same. Potential bull market gains are diminished by the cost of SDS calls, and the gains in a bear market from the calls offset only a small part of the loss.
Our scenario ignores the impact of rebalancing, which could benefit or hurt your performance depending on the sequence of the declining days. But it does show that buying shares of SDS basically amounts to a market neutral strategy with only small gains or losses possible. Using calls offers some downside protection but possibly not as much as most investors hope for. SDS calls only help you preserve wealth if there is a relatively large decline in the market.
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Be wary of inverse funds which might offer less protection than you assume they do. The bottom line is that holding this kind of portfolio insurance is expensive, and the damage it does to the growth of wealth in a bull market could be significant.
Rather than using insurance, it might be better to follow the market and take steps to protect your account only when stocks are falling. A long-term moving average, like the 10-month or 200-day, could help you spot bear markets and allow you to participate in the gains of a bull market.