Another popular and most commonly pursued strategy pertains to hedging of the risk of the portfolio through the application of derivatives. Derivatives refer to the contracts whose value is derived from the value of the underlying asset, from which the derivative contract is created. The basic classifications of derivatives are:
These are the very basic derivatives and several complicated products have been made from them. These derivatives can be applied to hedge the risks of the portfolio by taking an opposite position in the derivatives market to the position that has been established in the asset market. As an example, an investor who is long a stock in the stock market can hedge it by taking a short position in the derivatives market. Thus if the investor looses in the stock market, the loss is partly offset by the gain in the position in the derivatives market which reduces the risk of the investor.