Myth-busting about derivatives: Are they right for your portfolio?

Making the decision to use derivatives in your portfolio can seem daunting if you don’t know where to start.

But—as economic cycles and investment opportunities change—it can be helpful to consider how derivatives can assist you in reaching your wealth goals.

If you’re fully invested and concerned about a market correction, derivatives can help you put a floor under your holdings and limit downside risk. If you're more interested in enhancing potential gains while minimizing risk, derivatives can help you do that, too. If you're looking to get invested, derivatives can help put money to work in ways which can capitalize on market opportunities.

Knowing when and how to use these investment devices, however, means first dispelling some of the prevailing myths. Like all investments, derivatives do entail financial risks, including liquidity, counterparty and credit risks, but they can also help enhance your portfolio.

Here, we look at—and debunk—the five most common misperceptions that some investors still hold.

Myth 1: “Derivatives are so technical and complex, they’re all better left to professional investors.”

Of course derivatives can be complex, but they don’t have to be. Derivatives are financial instruments that can be tailored to specific investor needs. They’re contracts deriving value from what they’re tied to, including stocks, bonds, commodities, currencies and other tradeable things.

It may help to think about derivatives like Legos: Each one is a building block that can be used to build something sophisticated and complex—or functional and straightforward. What’s important is to make sure that you convey your specific portfolio objectives and your risk tolerance when you work with a financial institute to determine a suitable approach for you.

Many professional traders and financial institutions use derivatives and so do governments, corporations, family offices and individuals. The types of derivatives they use, however—and the purposes they serve—may differ widely. Many investors commonly use derivatives to mitigate or limit potential investment losses, generate income and speculate on asset-specific price movements.

Myth 2: “Derivatives involve market speculation, so they don’t fit with my investment goals”

Sometimes, derivatives are used for speculation—but not always. For example, we often see investors use derivatives to:

• Protect against downturns: Some investors hedge equity exposure by buying put options—a bearish strategy most often used as an alternative to shorting stocks—to protect against a downturn in the market without having to sell off their equity holdings.
• Add risk: Some investors buy call options—which give the buyer the right to acquire an underlying stock at a specified price within a certain time period—to leverage any upside returns by increasing market exposure on the expectation of future gains.
• Gain access: At other times, investors use derivatives to add exposure to certain asset classes or markets that may be harder to access, like commodities, interest rates, or currencies, and express specific views on, say, oil and copper prices.

Across the asset management industry, many derivatives are still primarily used to manage risk rather than speculate on market movements. By employing derivatives, you can turn a long-only equity portfolio, for example, into a more nuanced investment, with various potential payouts tailored to your individual needs.

You can also use derivatives to transfer risk between asset classes. In an uncertain market, for example, it’s possible to transition risk from fixed income to equity without selling out of your underlying holdings.

Myth 3: “Derivatives come with too many fees and lack transparency”

Derivatives don’t have to be costly or confusing. While there are costs associated with their use, derivatives strategies offer differentiated return patterns and greater potential diversification. By making use of derivatives, you can mitigate the risks that come with a long-only investment, where you are fully exposed to all potential market gains and losses.

Derivatives can also help you get more comfortable with many inherent risks in your current portfolio. How? By putting a floor under potential losses and helping you stay invested, even when markets turn volatile. Over the long term, remaining invested—and mitigating downside risk—is a goal that may help you efficiently realize future gains.

As portfolio tools, derivatives can also be readily customized. Using these strategies can be akin to remodeling a house: Inevitably, you have to decide which alterations are essential—and how much to budget for them. Derivatives are no different. Ultimately, the right balance of cost and complexity will be completely individual to you.   

Derivatives carry risks where investors could be subject to losses, so having a thorough understanding of products’ risk/reward profiles is crucial to help ensure that the derivatives contracts you enter into are aligned with your investment goals. Before purchasing these types of products, make sure you understand their terms. See important disclaimers at the end of this article for more information.

Myth 4: “When I enter into a derivatives contract, isn’t the bank on the opposite side of my position?”

The counterparty on the other side of a derivatives contract is typically a financial institution–and most commonly a bank–that is willing to buy and sell tradeable assets, such as derivatives contracts, to make markets. These firms provide liquidity to their clients and facilitate the trade of derivative products. For investors, it’s useful to think about this service as one that balances risk and reward: Counterparties can help you disperse your portfolio risk in the market. The more confidently a financial institution can effectively handle and distribute that risk in the market, the more competitively they can price derivatives contracts.

Myth 5: “Hedging with derivatives always results in a loss”

Hedging with derivatives is similar to taking out an insurance policy. Buying insurance doesn’t mean that the hazard you’re seeking to protect yourself from will happen—only that your losses will be limited in the event that it does. While using derivatives to hedge a portfolio exposure does come at a cost, knowing that you have that policy in place can help increase your confidence.

Ideally, you would never need that portfolio protection. But, if an adverse market event were to occur, having a derivatives strategy in place could help you weather the volatility and invest for the long term. If you’re able to maintain your investment positions despite market fluctuations, your portfolio may be better placed to capture meaningful growth trends over your particular investment horizon.

We can help

At J.P. Morgan, we think derivatives along with prudent financial advice can help you better manage portfolio risk over time and achieve better investment efficiency. If you’d like us to explore how these strategies could support you in realizing your wealth goals, speak with your J.P. Morgan team.