So far we’ve treated derivatives as ways to take a position. But their original purpose — and still their biggest use — is hedging: taking an offsetting position to reduce a risk you already carry.
Hedging is insurance, not a bet
A speculator uses a derivative to add exposure. A hedger uses one to cancel exposure. If you sell oil for a living, a falling oil price is already your risk; a hedge is a second position that gains when that risk hurts you, so the two roughly cancel.
Hedging with futures: lock in a price
A future obligates both sides, which makes it perfect for locking a price today for a transaction later.
- A farmer expecting to sell wheat at harvest sells wheat futures now. If the price falls, the futures gain offsets the cheaper crop. Price locked.
- An airline worried about fuel costs buys fuel futures. If fuel rises, the futures gain offsets the bigger bill.
The catch: a future is symmetric, so it removes the upside too. The farmer who locks in is protected from a price fall — but gives up a price rise. That certainty is the whole point.
Hedging with options: a floor, not a lock
An option hedges differently. Because it’s a right, it caps the bad side while keeping the good side — for a premium.
- An investor holding shares buys a protective put. If the market falls, the put gains and floors the loss. If it rises, they simply let the put expire and keep the gains.
A put is like insurance: you pay a premium, and you’re covered below the strike. Futures lock the price; options put a floor under it.
A worked example
You own 100 shares at $50 ($5,000). You fear a drop but want to keep the upside, so you buy one $45 put for $2/share ($200).
- Stock falls to $35: shares lose $1,500, but the put lets you sell at $45 — your loss is floored at $5/share plus the $2 premium = $700, not $1,500.
- Stock rises to $60: the put expires worthless (−$200), but your shares gained $1,000 — net +$800.
You paid $200 to cap the downside while keeping most of the upside.
The cost of hedging
Hedging is never free. With futures you give up the favourable move; with options you pay a premium. There’s also basis risk — the hedge and the thing you’re hedging may not move in perfect lockstep. A hedge trades some upside (or some cash) for less uncertainty.
The takeaway
Hedging flips a derivative from offence to defence. Futures lock a price (symmetric, no premium, no upside); options floor a price (asymmetric, premium paid, upside kept). It’s how a farmer, an airline, or a fund sleeps at night.