Since derivative prices and cash prices are inter-related, they can be used to reduce or increase risk of owning the asset (cash market). For example, buying an asset in the spot (cash) market and selling the futures contract on the same or selling a call option on the same reduces the investor’s risk.
If the price of the asset falls, the price of the futures contract on the same will also fall, so the investor can buy the same at the lower price and make a profit on the futures contract.
The premium on the call option will partially off-set the loss due to the price fall in the spot market. This is a typical hedge.
Derivative markets enable those wishing to reduce their risk to transfer it to those wishing to increase it, whom we call speculators. As these markets are so effective at reallocating risk among investors, no one need assume an uncomfortable level of risk.
On the other side of hedging, is speculation. Unless a hedger can find another hedger with opposite needs, the hedger’s risk must be assumed by a speculator. Instead of trading the specific stock or bond (cash market), one can trade in their derivative contracts.
Even though derivatives have been started for hedging they have been accused as being used for speculation and many big names have been closed down because of incorrect use of derivatives, which we shall look at later in this program.