Derivatives can be used in risk management to hedge a position, protecting against the risk of an adverse move in an asset.

A financial instrument whose price depends on the underlying asset, a derivative is a contractual agreement between two parties in which one party is obligated to buy or sell the underlying security and the other has the right to buy or sell the underlying security. Hedging is the act of taking an offsetting position in a related security, which helps to mitigate against opposite price movements.

For example, assume an investor bought 1,000 shares of Tesla Motors Inc. on May 9, 2015, for $65 a share. He held onto his investment for over two years and is now afraid that Tesla will be unable to meet its earnings per share (EPS) and revenue expectations.

Tesla's stock price opens at a price of $243.93 on May 15, 2018. The investor wants to lock in at least $165 of profits per share on his investment. To hedge his position against the risk of any adverse price fluctuations the company may have, the investor buys 10 put option contracts on Tesla with a strike price of $230 and an expiration date on Sept. 7, 2018.

The put option contracts, which are a type of derivative, give the investor the right to sell his shares of Tesla for $230 a share. Since one stock option contract leverages 100 shares of the underlying stock, the investor could sell 1,000 (100 x 10) shares with 10 put options.

Tesla is expected to report its earnings on Sept. 5, 2018. If Tesla misses its earnings expectations and its stock price falls below $230, the investor has locked in a sell price of $230 with his put options. So he could sell 1,000 shares, gaining a profit of $165 ($230 - $65) per share.

  1. What Does It Mean to Be Long or Short a Derivative?

    Find out more about derivative securities and what it indicates when traders or investors establish a long or short position ... Read Answer >>
  2. Who are Tesla's (TSLA) main competitors?

    Learn about Tesla Motors' competitors, some of which are over a century old and others that are much younger. Find out about ... Read Answer >>
  3. How is the price of a derivative determined?

    Learn how different types of derivatives are priced, including how futures contracts are valued and the Black-Scholes option ... Read Answer >>
  4. How big is the derivatives market?

    Learn how different calculations can reduce the estimate of the total derivatives market by as much as 90 to 95%. Read Answer >>
Related Articles
  1. Investing

    Tesla Stock: An Earnings Case Study (TSLA)

    Pay attention to whether Tesla’s quarterly vehicle deliveries continue to outweigh quarterly earnings and revenue from investors’ standpoints.
  2. Investing

    Tesla's Stock To See High Volatility, Option Trades Show

    The options market is betting that Tesla stock prices will rise or fall 7% over the next 3 weeks.
  3. Investing

    Tesla Short Interest Surges Ahead of Earnings

    Tesla is ripping through cash and a record number of short-sellers are taking notice.
  4. Investing

    Tesla Stock Drives Off a Cliff (TSLA)

    While consumers may soon be able to afford the Tesla of their dreams, it's going to be a bumpy ride for Tesla shareholders.
  5. Investing

    Tesla: Tech Company or Car Company?

    Tesla has the growth prospects of a tech company but resembles the auto industry in its capital-intensive operations.
  6. Investing

    If You Had Invested Right After Tesla's IPO

    Find out how much you would have earned if you had invested in Tesla, Inc. right after its initial public offering, or IPO.
  7. Insights

    Will Tesla Stock Drive Higher After Earnings? (TSLA, SCTY)

    Tesla will look to build on this momentum Wednesday when the electric car company reports third quarter earnings.
  8. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  9. Investing

    How Oil Prices Affect Tesla's Stock (TSLA)

    Pay close attention to Tesla’s share price performance before assuming that shockingly low oil prices can provide a bargain for purchasing Tesla shares.
  10. Investing

    Why Tesla's Stock May Soar 60%, Then Plunge: Morgan Stanley

    Flying High: Tesla's stock could initially soar, then face major turbulence
  1. Underlying Security

    An underlying security is a stock, bond, currency, or commodity ...
  2. Underlying Asset

    An underlying asset is a financial instrument upon which a derivative's ...
  3. Put

    An option contract giving the owner the right, but not the obligation, ...
  4. Selling Hedge

    A selling hedge refers to investment strategies involving contracted ...
  5. Long Put

    A long put is buying a put option, which profits if the underlying ...
  6. Energy Derivatives

    Energy derivatives are financial instruments in which the underlying ...
Trading Center