Derivatives can hedge specific risks or adjust a portfolio at a known cost, but they are not needed to invest well, and for most people the right allocation is zero.
8 min read · Level 5
I would go further than most educational material and say that the default allocation to derivatives for an individual investor is zero, and that the burden of proof is on the trade. Almost everything an ordinary investor needs from a portfolio can be achieved without them. The handful of genuine exceptions are specific enough that you will recognise one when you have it, and if you are searching for a reason to use derivatives, you probably do not have one.
A good long-term portfolio can be built entirely without derivatives. Diversification, asset allocation, position sizing and holding enough cash already manage most of the risks derivatives are sold to address.
The narrow cases where derivatives can genuinely help:
Situation Possible use A large, concentrated holding you cannot sell yet a protective put or collar, at a known cost A business with real exposure to a price futures to hedge that exposure An experienced investor adjusting risk precisely options as a deliberate tool with defined loss
What these share is that the derivative offsets an existing risk. Using derivatives to add risk - speculating on price moves - is a different activity, closer to trading than investing, and for most individuals it has poor expected results after costs.
If you decide to use derivatives for speculation anyway, the only defensible structure is a small, fixed amount of money you have already decided you can lose completely, kept separate from the rest of your portfolio.
Because the tools are powerful and the marketing is constant. Brokers promote options trading, social media highlights big wins, and short-dated contracts have made rapid speculation easy. None of that changes the maths from earlier lessons.
Keeping derivatives out of the core portfolio also protects the parts of it that matter most from a sudden, forced loss.
This is educational information, not investment, securities or financial advice. Rules differ by country and change — get advice from a qualified professional in your jurisdiction before acting.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Sources: UK FCA - information for consumers; U.S. SEC - Investor.gov; FINRA - Investor Insights
Two investors, each holding 500,000.
Investor A holds 300,000 of one company's shares from their employer, locked for a year. They buy protective puts on part of the holding, accepting a known cost to limit the damage if that single company collapses before they can diversify.
Investor B holds a diversified portfolio and trades short-dated calls with 20,000 a year, hoping to boost returns.
Investor A is using a derivative to reduce a risk they already have. Investor B is adding a risk they did not need. A may still decide the insurance is too expensive, but the question is at least the right one.
Treating derivatives as a way to improve returns on a portfolio that is already sensibly built. For most investors they add cost and risk without a clear benefit.
If the answer is none, you are speculating. Decide deliberately whether you want to do that at all.
Reducing a position, diversifying or holding more cash often achieves the same goal more cheaply.
Set an amount you will treat as spent, keep it separate, and stop when it is gone.
When you have a specific, identifiable risk - such as a concentrated holding you cannot yet sell - and have compared hedging costs with simpler alternatives.
When the goal is extra return, excitement or recovering earlier losses. For most people, owning no derivatives is the correct position.
The UK FCA and the European Securities and Markets Authority introduced restrictions on the sale of contracts for difference and similar leveraged products to retail clients, including leverage limits and required risk warnings stating the percentage of retail accounts that lose money with each provider.
When regulators require a firm to publish how many of its customers lose money, read that number before anything else.
Create a free account to read the rest and apply it to your own investing.