Why does financial investor bother to buy derivatives and then hedge the position?
Sometimes hedging is used if you have a position and you feel the market is going against your position, so one would hedge that position in order to protect their capital and possible profits instead of closing the position and incurring capital gains tax. Personally if the market was going against a position I had open I would get out of that position and protect my capital/profits instead of using more capital to hedge against my position. I would rather take a profit and pay some capital gains tax than watch my profits turn into a loss or use up more capital to try and protect a bad position. Hedging can be useful in certain circumstances but I think if you feel the market is going against your position/s for the medium to long term you should just get out of your positions instead of hedging against them. I don't know why a financial investor or a retail trader would do this. But I can guess why a market maker in options would do this. Let us say you buy an option from an option market maker and the market maker sold the option to you. He made a small profit in the bid-ask spread but now he is holding a short position in the option with unlimited risk exposure. So to protect himself, he will take an offsetting position in the underlying and become delta neutral, so that his position is not affected by the moves in the underlying. In the end, he can do this because he is not in the market to make money by betting on direction, unlike the rest of us poor mortals. He is making money from the bid-ask spread. So to ensure that his profits are not eroded by an adverse move in the underlying, he will continuously seek to be delta neutral. But once again, this is for a market maker. For market takers like us, I still don't understand why we would need to delta hedge. There are a number reasons to hedge a position.  Here are some of the more common:
"How do option market makers actually hedge their positions so that they do not have a price risk? You cannot complete hedge away price risk of a sold call simply by buying the underlying and waiting.  As the price of the underlying decreases, the ""Delta"" (price risk) decreases, so as the underlying decreases, you would gradually sell some of the underlying to reduce your price risk from the underlying to match the price risk of the option. The opposite is true as well - as the price of the underlying increases, you'd buy more of the underlying to maintain a ""delta neutral"" position. If you want to employ this strategy, first you need to fully understand what ""delta"" is and how to calculate it.  Then you can use delta hedging to reduce your price risk." If you hold a future plus enough cash collateral it is economically equivalent to owning the underlying asset or shorting the underlying asset. In general financial assets such as stock indices have a positive expected return - that's the main difference between investing and gambling. There's nothing that special about futures, they are just another contractual form of asset ownership.  Well, one difference is that regulations or brokerages allow individual investors more leverage with options and futures than with straight borrowing. But this is more a regulatory issue than a conceptual issue with the securities themselves. In theory regulators or brokers could require you to hold enough collateral to make a future equivalent to buying the underlying. Generally, anyone can. Selling them is an interesting point, as the buyer has a counterparty risk that you won't be able to pay at the term of the contract. So, if I was a vendor buying a derivative in my example, I would definitely get that derivative from a bank as opposed to my friend Jim Bob. Especially in cases of bespoke derivatives, it doesn't make sense for anyone except people who have material interest to by it, as the expectation value of the hedge is negative. Essentially, you're more likely to lose money than gain money from a hedge. The exception is when you have information above that of the market, which could allow for a positive return. That is the reason that people advocate for derivatives as mechanisms of price discovery, because large imbalances aren't likely to form when someone could arbitrage or even just take positions when the market goes out of whack. That only really works in publically traded markets, however, bespoke derivatives don't really contribute to better pricing afaik.  Of course, that's the simple explanation to a huge, complex, and varied field. Certainly, speculators exist, particularly in the more commoditized derivatives. Especially in the leadup to the financial crisis, large amounts were spent on exotic derivatives that blew up in people's faces. The easiest thing to say about them is that they are double edged swords. In theory, they're fantastic, as it allows risk to be spread around to people that want it. It should lead to a safer system, as hedged comapnies are less exposed to shocks and are more resilient. But in practice, we've alao seen them used as risk concentrators (AIG). We've seen cases where correlations arise that weren't assumed before, and what used to be manageable positions become lead weights. We've seen the dangers that large systemically important financial institutions have when they are a counterparty to tens of trillions in notional derivatives, as when they fail the risk of failure is over every derivative they are counterparty to, not just the hedged exposure.   Sorry, this is more than you asked for. I tend to get carried away. An option gives you an option.  That is, you aren't buying any security - you are simply buying an option to buy a security.  The sole value of what you buy is the option to buy something. An American option offers more flexibility - i.e. it offers you more options on buying the stock.  Since you have more options, the cost of the option is higher. Of course, a good example makes sense why this is the case.  Consider the VIX.  Options on the VIX are European style.  Sometimes the VIX spikes like crazy - tripling in value in days.  It usually comes back down pretty quick though - within a couple of weeks.  So far out options on the VIX aren't worth just a whole lot more, because the VIX will probably  be back to normal.  However, if the person could have excercised them right when it got to the top, they would have made a fortune many times what their option was worth.  Since they are Euroopean style, though, they would have to wait till their option was redeemable, right when the VIX would be about back to normal.  In this case, an American style option would be far more valuable - especially for something that is difficult to predict, like the VIX. "I don't know why people ask these types of questions.  Do you have an interest in the business world?  Do you play the stock market, or do you at least follow some companies?  Do you read about hedge funds?  Do you read about algorithmic trading? If the answer is ""no"" to all of these, then consider something else.  I've seen too many people in the industry who are desperately unhappy because they have no interest in the industry, but are hooked on the money." You appear to be thinking of option writers as if they were individuals with small, nondiversified, holdings and a particular view on what the underlying is going to do.  This is not the best way to think about them. Option writers are typically large institutions with large portfolios and that provide services in all sorts of different areas. At the same time as they are writing calls on a particular stock, they are writing puts on it and options on other stocks.  They are buying and selling the underlying and all kinds of different derivatives.  They are not necessarily writing the option because they are expecting or hoping to benefit from a price move.  It's just small part of their business.  They write the option if the option price is good enough that they think they are selling it for very slightly more than it's worth.   Asking why an option writer creates a call is like asking why a grocery store keeps buying groceries from their distributors.  Don't they know the price of food may not always rise?  Sure, but their business is selling the food for slightly more than they pay for it, not speculating on what will happen to its price.  Most option writers are doing the same thing, except what they are buying and selling is sets of cash flows and risk.   As a general rule, the business model of option writers is to profit from the few cents of spread or mispricing, not from aggregate changes in the price of the underlying.  They should and often do maintain balanced portfolios so their option writing activities don't expose them to a lot of risk. Also note that there could be lots of reasons for writing options, even if you do have a particular view.  For example, perhaps the option writer thinks volatility of the underlying will decrease.  Writing a call could be part of an overall strategy that profits from this view. And just as easily, someone could find a reason for such a derivative to exist.  Let's say I'm a vendor of memorabilia for a given sports team, but unlike most vendors I'm only a vendor for a particular team.  Given that there is a large lead time between orders placed and memorabilia received (perhaps on the order of a month between order and receipt), it is inherently risky to order large orders towards the end of a season.  However, if they're going to be in the playoffs, there's a huge opportunity to sell, but if they don't, you'd be left with tons of surplus inventory.  So, wouldn't it be handy for there to be a way to hedge that risk?    We've actually seen times when such things aren't unreasonable.  Large risks are [hedged away](http://online.wsj.com/article/SB10001424052702303877604577380593015786140.html), even in sports. The point of derivatives is to get rid of the risk you don't want so you can acquire exposure only to the risk you want. Who wants weather/temperature risk -- speculators. Who doesn't want that risk? Anyone who's core business is adversely affected by bad weather. It's the same reason multinational firms will hedge FX and interest rates. All a speculator is typically doing is taking the other side of the trade based on what they feel is the true price of the risk they are assuming It's a con being played upon the middle money people by the big money people and it's based on the Bernoulli Principle or Venturi Effect. Simply put -- and in analogous form -- if a lot of something goes in one direction, then a lot of other similar somethings will go in the same direction too. So, if a lot of big money gets invested into derivatives then other money will follow. That original big money is called the primer -- it primes the pump flow and gets the other money following it in. If the original money, the primer, gets removed from the process it doesn't stop the flow of other money into the flow because once the flow is going, any new money in the process acts like the original primer money, sucking in even more money; this is the Venturi Effect in action -- it's how most pumps work.  So, you prime the pump, get it flowing nicely, move your priming money out of the process and wait for the thing to suck out as much money as the economy can withstand and then *crash,* er, profit! If you've set your stakes correctly to benefit from the stopping of the flow -- the crash -- you can make billions with very little effort and practically no risk at all. The first thing that I learned the hard way (by trying my hand at actual options trading) is that liquidity matters. So few people are interested in trading the same options that I am that it is easy to get stuck holding profitable contracts into expiration unless I offer to sell them for a lot less than they are worth.  I also learned that options are a kind of insurance,and no one makes money (in the long run) buying insurance.  So you can use options to hedge and thereby prevent losses, but you also blunt your gains.  Edit: IMO,options (in the long run) only make money for the brokers as you pay a commission both on the buy and on the sell. With my broker the commission on options is higher than the commission on stocks (or ETFs). Well, if you only own the option, you are only limited to loosing the premium. With futures, at least with the brokers I talked to, most of the time you need to sign a margin contract just to trade futures. I don't want to go into debt, and I don't think I would do too well to be fairly honest. I am a college student, and want to limit my risk, and so just trading the option would help me get access to the commodity markets without having to get margin like many brokers want me to do. I am not trying to do any hedging or anything (which I am aware you can do). All I want to do is do an inflation trade, and I believe commodities are the best way. To me honest, if I had my way I would just buy and hold, and that is the strategy I want to emulate closest, even though I know I can't hold it forever. Basically, I want to avoid debt, but still trade commodities. "I know some derivative markets work like this, so maybe similar with futures.  A futures contract commits two parties to a buy/sell of the underlying securities, but with a futures contract you also create leverage because generally the margin you post on your futures contract is not sufficient to pay for the collateral in the underlying contract. The person buying the future is essentially ""borrowing"" money while the person selling the future is essentially ""lending"" money. The future you enter into is generally a short term contract, so a perfectly hedged lender of funds should expect to receive something that approaches the fed funds rate in the US. Today that would be essentially nothing." Intuitive? I doubt it. Derivatives are not the simplest thing to understand.  The price is either in the money or it isn't. (by the way, exactly 'at the money' is not 'in the money.') An option that's not in the money has time value only. As the price rises, and the option is more and more in the money, the time value drops. We have a $40 stock. It makes sense to me that a $40 strike price is all just a bet the stock will rise, there's no intrinsic value. The option prices at about $4.00 for one year out, with 25% volatility. But the strike of $30 is at $10.68, with $10 in the money and only .68 in time premium. There's a great calculator on line to tinker with.  Volatility is a key component of options trading. Think about it. If a stock rises 5%/yr but rarely goes up any more or less, just steady up, why would you even buy an option that was even 10% out of the money? The only way I can describe this is to look at a bell curve and how there's a 1/6 chance the event will be above one standard deviation. If that standard deviation is small, the chance of hitting the higher strikes is also small.  I wrote an article Betting on Apple at 9 to 2 in which I describe how a pair of option trades was set up so that a 35% rise in Apple stock would return 354% and Apple had two years to reach its target. I offer this as an example of options trading not being theory, but something that many are engaged in. What I found curious about the trade was that Apple's volatility was high enough that a 35% move didn't seem like the 4.5 to 1 risk the market said it was. As of today, Apple needs to rise 13% in the next 10 months for the trade to pay off. (Disclosure - the long time to expiration was both good and bad, two years to recover 35% seemed reasonable, but 2 years could bring anything in the macro sense. Another recession, some worldwide event that would impact Apple's market, etc. The average investor will not have the patience for these long term option trades.) Vanguard has a lot of mutual fund offerings.  (I have an account there.)  Within the members' section they give indications of the level of risk/reward for each fund. Buy it at the close. That way you won't lose money (even if marked to market) on the day.