Using a combined trading and investing approach to your advantage

A strategy that combines shares and derivatives gives you more control over the amount of volatility and risk you’re able or willing to take on.

For instance, if one of your long-term shareholdings is in a period of heightened growth, you can temporarily increase your exposure by taking a long position on that share to benefit from its price momentum.

This also holds true for shares you don’t already own or even markets you don’t typically participate in. That’s because you can trade derivative products on several financial asset classes like commodities, stock indices and currency pairs.

Using this strategy to manage your risk

Derivative instruments are risky, but they can also be used to reduce risk in your portfolio. They do that in two ways: diversification and hedging.

Diversification

As the old adage goes, you shouldn’t put all your eggs in one basket. That’s where diversification comes in. This is the practice of investing in a range of different asset classes, countries and sectors in order to reduce risk in a portfolio.

To successfully diversify a portfolio, you need to think carefully about how different market conditions can impact the investments you hold. Adopting an ‘if this happens, then that will happen’ mindset is useful here.

Trading derivative instruments is one way to diversify your portfolio. These instruments can help balance out overexposure in a share portfolio. This can be done by taking out futures contracts in assets not represented in your portfolio.

You can rebalance your portfolio in a few ways, namely by:

• Taking profits made from the assets that are overweighted in your portfolio
• Buying assets that are unrelated to the ones you already own
• Waiting for the market to restore balance with a falling share price

Once balance is restored, you can close your derivative positions in the market until you need to diversify your holdings again.

Hedging

Hedging is the practice of reducing exposure to an existing investment by placing a derivative trade in the opposite direction. This might sound slightly confusing, but it can be useful in mitigating short-term losses in your portfolio.

As you now know, even a long-term winning share can experience short-term drops in price.

For example, an upcoming financial results announcement from a company in which you have long-term holdings could negatively impact the value of your investment in the short term. If you’re expecting this, you can temporarily take a short position on the company’s shares to limit the impact to your portfolio.

The falling share price will negatively affect your long-term holdings, but because you’re making money on the short position you took, your combined investment and trading portfolio is relatively unaffected.