How can you hedge your portfolio against uncertainty?

What if there was a way to protect your portfolio? Would you consider capping your gains in exchange for reducing potential losses? What if there was a way to protect your portfolio in a cost-effective way?

Well, there is.

In an unpredictable market environment, timing the market is nearly impossible. Instead, adopting a strategy that can help protect against  uncertainty can be invaluable. By aligning your investment approach with your goals, you may better preserve your portfolio and potentially position it for growth across various market conditions, ensuring you remain invested for the long term.

Derivatives can help investors navigate many of today’s pressing investment challenges. These contracts are not without risks, as they can be more complex than traditional investment products. They involve risks such as liquidity, counterparty and credit risks, and investors must meet suitability requirements to trade them. But working with the right investment partners can help minimize them, and we believe derivatives can be an important tool for managing your investment portfolio.

Here’s an introduction to help you consider whether, and when, derivatives might be appropriate additions to your investing toolkit to help achieve your goals.

It’s an interesting moment for derivatives

Derivatives are financial instruments that are contracts deriving value from what they’re tied to, including stocks, bonds, commodities, currencies and other tradeable things such as indexes, interest rates—and even the weather. Several factors right now are bringing derivatives to the fore:

• Elevated interest rates: Rates are significant drivers of derivative pricing. Higher interest rates can lead to interesting derivative opportunities. (For example, one class of derivatives, structured notes, particularly benefits from high interest rates.) While rates are elevated now, that may not last. That’s why we like the timing today.
• Strong economy in a fragile world: As our 2024 Mid-Year Outlook title says of the new environment, economic outlooks are strong, yet geopolitical risk is top of mind for investors and can hinder plans to stay invested. And we believe our clients should be fully invested. Derivatives can help hedge against uncertainty and allow for longer-term investing time horizons.
• New accessibility: Historically, only the most sophisticated investors could purchase derivatives. Today, at a time when we think there may be particularly interesting opportunities, derivatives have also become more accessible to individual investors—and in bespoke forms.

Whatever your goals, from preserving capital to adding income and more, derivatives can be customized to help you achieve them.

What are derivatives—and how can they enhance your portfolio?

Derivatives can be traded on an exchange or in the over-the-counter (OTC) market; each offers different types of derivatives contracts. Investing in derivatives makes you a party to a binding agreement, and they are a flexible product that can be used to achieve multiple goals, but often designed to hedge against various portfolio risks or enhance potential yield.

Examples of derivatives include:

• Forward contracts—Two sides agree in a private OTC market to buy or sell an asset at an agreed price and date in the future
• Futures—Similar to forwards, but traded on an exchange
• Options—Similar again, but they give the buyer the right, although not the obligation, to buy (“call”) and sell (“put”) at a predetermined price in the future. Meanwhile, the seller has the obligation to fulfill the terms if the buyer exercises the option. They can be traded on an exchange or OTC
• Structured products—Created by pairing a fixed income instrument with a package of OTC derivatives
• Swaps—A derivative contract where two parties agree to exchange cash flows based on the future performance of two different financial instruments for a specified period of time

When considering derivatives, you’ll want to consider your objectives, risk tolerance and need for liquidity, among other factors. Here are a few things derivatives can help you accomplish.

Hedge against portfolio risks: Derivatives can allow you to hedge against risks on both the asset and liability sides of your balance sheet. For equities, you might use derivatives to hedge against a decline in a portfolio or single stock to limit potential losses.

Another derivative, an interest rate swap, allows investors to hedge against fluctuations in interest rate movements by locking in rates or borrowing costs.

Potentially enhance risk-adjusted returns: An investment’s value can rise or fall, of course. The decision to take on full upside and downside risks can be daunting. But certain derivative strategies can be constructed to adjust that. If, say, you’re looking to reflect certain market views in your portfolio, derivatives can help create a more compelling risk/reward profile than simply holding a traditional long-only cash investment.

For example, a structured note can allow you, for a price, to cap some of your upside potential in exchange for embedding a floor, or maximum loss, on the downside.

Provide an approach to generating income: Fixed income, a common portfolio staple, has some limitations. Price and yield, for example, are set by the current market environment. You might not want what’s available. A structured note can take other assets—investment grade financials or technology stocks, for example—and turn them into income-producers.

Certain types of derivative products can allow investors to monetize the risk premium embedded in an asset class such as equities and turn it into an income generator. Its payment to the investor reflects equity market risk, plus some embedded downside protection—with the potential to pay more than public fixed income markets.

Potentially provide tax efficiency:  By incorporating derivatives into their portfolios, investors may be able to strategically manage their investments to reduce overall tax liabilities while maintaining market exposure. Leveraging derivatives in this manner can potentially lead to smarter, more tax-efficient investment outcomes and improved after-tax returns

Derivatives and structured products, like most investment products, come with a degree of risk. Before purchasing such products, make sure you understand their terms. See important disclaimers at the end of this article for more information.

A case study: Derivatives in real life

How could a strategy actually work? Among the possibilities, here is an example.

Achieving leveraged upside exposure

Tom is looking to purchase a vacation home in Switzerland, as he is an avid alpine skier. He thinks the tech sector will return more than the broad market over the short term, and wants to act on this conviction. But with his pending house purchase, he doesn’t have enough liquidity to buy stock up front, and he doesn’t want to sell holdings in his diversified portfolio.

His team helped him choose a growth-focused single tech stock poised to potentially benefit from the rollout of its new artificial intelligence (AI) enhanced product. Given the compelling outlook, he bought a call option that allowed him to potentially buy the stock if it appreciated to a specified level. He only needed to pay a small outlay (the “premium,” or the option’s price), which was less than the value of the underlying stock. His maximum loss on this position was also limited to the premium.

During the options contract, the tech stock generated positive returns on the call option, as the stock appreciated after the company’s new product rollout. This prompted Tom to exercise his contract. The call option gave Tom the extra tech exposure he wanted, did not disrupt his portfolio’s diversification, and limited his downside risk.

All derivatives and structured products offered on our platform go through J.P. Morgan’s rigorous investment strategy process. Reach out to your team to learn more about our platform and to see how our comprehensive derivatives products and strategies, suited to various needs, may enhance your portfolio.