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If you’re a regular Financial Review Smart Investor reader, you’ve been investing for some time and are comfortable buying and selling listed shares. You take an active interest in managing your portfolio, which means you like to crunch the numbers yourself when looking at the financial data of a prospective investment. And you may be comfortable using borrowed money to invest.

Sound right? Then chances are you’re already trading derivatives as part of your strategy to protect and build up your wealth. And if you’re not, perhaps you could be.

Over the past couple of years derivatives were lumped in with a range of dodgy and complex financial products, the likes of which underpinned an almost total collapse in the global financial system. Investment guru Warren Buffett memorably dubbed the more arcane derivatives “financial weapons of mass destruction”.

Trading derivatives, such as options, is a more complicated proposition than, say, buying or selling shares in Woolworths. The potential payoffs and losses require a little more attention than “stock goes up, I win; stock goes down, I lose”. But this flexibility gives investors strategies to protect themselves against losses and to make money even when an investment falls in value.

The basics

Let’s not get ahead of ourselves, so first some  basics. A derivative is a financial contract, the value of which fluctuates according to the movement in price of an underlying asset.

Options are a type of derivative product. They can be bought or sold through the Australian Stock Exchange, giving you the comfort of trading on a liquid market. Paying for a “call” or “put” option gives you the right to buy or sell, respectively, a bundle of shares at a given price. There’s no obligation to “exercise” your right – after all, that’s why it’s called an option.

Option contracts have a number of variables.

There’s the “strike price” at which you can buy or sell the shares; the expiry date (which can be years from now for the bigger stocks); and the number of contracts, with each contract generally equal to 1000 of the underlying shares.

Those three factors – and the current price of the underlying asset relative to the strike price – determine the total premium you pay (or the income you receive if you sell options, but more on that later). Contract prices are listed on the ASX website.

Contracts for difference are another type of derivative easily accessible by retail investors. Whereas ASX-listed options are standardised, CFDs sold by specialist providers are more flexible in terms of the underlying assets you’re able to reference – from physical commodities to individual shares or overseas indices – as well as in the size of the contract.

Both are available on margin, which means you pay a fraction of the value of the total effective exposure.

Still confused? Don’t worry, following are eight worked strategies (six using options and two using CFDs) showing how you can use derivatives to protect your portfolio and even to make a little money on the side.

Options versus CFDs

CFDs are riskier but more flexible. You can get a more precise hedge, both in terms of the level (or exact share price you wish to hedge at) and the position size.

Exchange-traded options as discussed here are less bespoke. Contracts are 1000 shares, although the head of derivatives at RBS Morgans, Wai-Yee Chen, says there’s talk of the ASX introducing 100-share contracts, perhaps to make the products more attractive to retail investors who may lean more towards the flexibility of CFDs.

The off-market products are also cheaper to enter into and conceptually easier to get to grips with. But complication can be a boon if it makes you think more about your financial decisions.

Finally, CFDs are live trades. Buying an option won’t force you into any action but a short position in CFDs that goes against you needs to be covered – and that may mean you have to sell assets to meet margin calls.

“This strategy is for active traders – people that monitor their positions,” says Chris Weston, who works on the institutional dealing desk of CFD provider IG Markets.

Chen isn’t a fan of CFDs. Her main issue with them is the counter-party risk involved when dealing with market-making CFD providers. Essentially, you have to trust the provider to fulfil its side of the contract. Things can happen, though, such as the collapse of Sonray Capital in mid-2010, which left thousands of investors millions of dollars out of pocket. “Trading derivatives is risky enough,” Chen says. “Why would you want to add more risk?”

While ASX-listed CFDs eliminate the counter-party risk, she says, they don’t have the liquidity you need to be able to get in and out easily when things really turn sour.

Weston, naturally enough, couldn’t disagree more, citing the flexibility and cost-effectiveness of CFDs. He’s vehement that FTSE-listed IG not be lumped in with cowboy outfits like Sonray.

“It’s important that you look at the individual provider’s stance on client money handling,” Weston says. “How would the client fare in the eventuality of the broker going into liquidation? How would their funds and running profits be treated?”

Your CFD provider should detail whether it uses its own (rather than client) money for hedging. Check that your funds are held in a government-regulated bank account here in Australia. IG Markets provides these disclosures on its website.

Employing derivatives does require some extra homework, but there’s no reason they can’t be used to your benefit if you use them sensibly.

Trading options or CFDs to take a heavily leveraged bet on the movement of an underlying asset is of course possible, but it’s a world apart from what we’re talking about here. You may as well be taking a punt on the horses.

Chen, an options expert and author, runs full-day courses in Sydney that you can find more about on her blog at www.optionswise.wordpress.com . The ASX also has online courses in options and offers occasional seminars (www.asx.com.au).

You don’t have to be scared of derivatives, but you do need to be informed.