Derivatives could be used in risk management by hedging a position to protect against the risk of an adverse move in an asset. Hedging is the act of taking an offsetting position in a related security, which helps to mitigate against adverse price movements.
A derivative is a financial instrument in which the price depends on the underlying asset. A derivative is a contractual agreement between two parties that indicates which party is obligated to buy or sell the underlying security and which party has the right to buy or sell the underlying security.
For example, assume an investor bought 1,000 shares of Tesla Motors Inc. on May 9, 2013 for $65 a share. The investor 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 opened at
a price of $243.93 on May 15, 2015. 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 August 7, 2015.
The put option contracts 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 * 10) shares with 10 put options.
Tesla is expected to report its earnings on August 5, 2015. If Tesla misses its earnings expectations and its stock price falls below $230, the investor could sell 1,000 shares while locking in a profit of $165 ($230 - $65) per share.