If markets were easy to predict, every investor would come out ahead. In reality, sudden swings and hidden risks tend to surface when confidence is highest, catching unprepared portfolios off balance and turning short-term stability into long-term concern.
That’s why seasoned professionals approach the market differently. They turn instead to a specific set of tools deployed by pension funds and Wall Street trading desks during every single trading session.
Charles Schwab just published a detailed guide on these contracts, and what the guide reveals may change how you approach defending your own savings.
The edge investing pros reach for when volatility starts to surge
Derivatives are financial contracts whose value depends on the price of another asset, such as a stock, commodity, interest rate, or currency pair. Rather than owning the underlying asset directly, an investor holds a contract linked to its price, which moves with the asset as it rises or falls.
Professional investors reach for these contracts primarily to hedge portfolios, meaning they reduce exposure to price swings they would rather not absorb in their accounts. A common hedge involves buying broad index put options before an expected period of market turbulence, according to Schwab’s guide by Joe Mazzola.
The hedge requires a premium paid upfront and pays off only when the feared drop occurs within the contract’s expiration window. Institutional investors, from pension funds to insurance firms, rely on these contracts in portfolios that manage trillions of dollars across global markets.
The notional value of outstanding over-the-counter derivatives runs into the hundreds of trillions of dollars globally, according to data from the Bank for International Settlements. That scale reflects how central these contracts have become to managing risk inside major institutional portfolios across developed and emerging markets today.
Contract types professionals use to manage risk
Schwab has highlighted four contract types for professionals seeking to manage their investment risk.
1. Options contracts
Options come in two forms, calls and puts, and remain the most widely used derivatives by individual investors and professional traders alike today, Schwab said.
A call grants the right to buy the underlying asset at a preset strike price by expiration, while a put grants the right to sell the underlying asset at a preset strike price by expiration. Put options are the standard tool for hedging downside equity risk, especially ahead of periods of elevated volatility in equity markets.
2. Futures contracts
Futures are standardized, exchange-traded contracts in which both parties commit to buy or sell an asset at a set price on a specific future date, Schwab explained.
A manufacturer might lock in today’s oil or wheat prices for a purchase six months out, significantly reducing uncertainty about future input costs. Because both sides are legally obligated under the contract, significant price moves above or below the agreed level create real losses for one party.
3. Swap contracts
Swaps are private, over-the-counter agreements in which two parties exchange cash flows, most commonly tied to prevailing interest rates over a defined period, according to Schwab. One side typically pays a fixed rate while receiving variable rate payments, with the counterparty taking the opposite position in the contract throughout.
These deals are used almost exclusively by corporations and large financial institutions, rather than by retail traders operating in a regular brokerage account today.
4. Forward contracts
Forwards resemble futures but are customized private agreements rather than standardized exchange-traded contracts between the two specific counterparties directly involved in the deal.
They carry higher counterparty risk because no central exchange clears the trade or guarantees either party’s performance under the private contract.
“We view a tail risk hedge, particularly in the current environment of monetary distortion and overvaluation, as more than protection but as a means for enhancing an investor’s long-term equity returns,” said Mark Spitznagel, CIO of Universa Investments, in a Hedge Fund Journal article.
Businesses typically rely on forwards to manage foreign currency exposure and commodity price risk across international operations, supply chains, and procurement activities.
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Risks to understand before any derivatives trade
Derivatives can amplify losses as readily as they cushion them, and regulators require specific account approvals before retail clients can trade these contracts.
Congressional Research Service analysis describes derivatives as “volatile contracts with a high degree of leverage, which can result in big gains and losses.”
Six distinct categories of risk deserve full attention before any investor opens a derivatives position inside a regular brokerage or retirement investment account.
- Leverage risk: Small upfront payments can turn minor price moves against you into losses that exceed your initial premium paid.
- Timing risk: A correct directional view still generates losses when the expected move occurs outside the contract’s expiration window.
- Interest rate risk: Shifts in prevailing rates affect the value of many contracts, especially those tied directly to interest rate movements.
- Liquidity risk: Some contracts become difficult to exit at fair prices during market stress, forcing traders into unfavorable transactions overall.
- Counterparty risk: Over-the-counter contracts depend on the other party meeting obligations, which may fail during a genuine market crisis.
- Operational risk: Valuation, margin, and settlement errors can compound quickly, and complex contracts require careful ongoing monitoring at all times.
These risks, highlighted by Schwab, are a major roadblock for many investors building their portfolios. For this reason, investors need to proceed with caution.
The exposure already sitting in your portfolio
Retail investors should also remember that many ETFs and mutual funds already use derivatives internally as part of their standard investment management approach. Derivative products require ongoing management and are not appropriate for every investor’s risk profile, according to the Commodity Futures Trading Commission.
Whether hedging belongs in your investing strategy
According to Charles Schwab, hedging with derivatives is not a beginner move, and it rarely makes sense for investors still building a core long-term portfolio from scratch today.
FINRA’s overview of options reinforces the point, noting that trading options requires specific approval from a brokerage firm and comes with different risks, depending on how the contracts are used.
The strategy works best when an investor has a specific, clearly defined risk to offset within a meaningful portfolio position they already hold. Before placing any derivatives trade, the firm suggests investors ask questions such as the following.
- Do you understand how losses are calculated at expiration, especially in a worst-case directional outcome for the contract held?
- Is there a specific identified risk you want to hedge, or are you primarily chasing speculative upside on short-term price moves?
- Can you afford to lose the entire premium or margin deposit without derailing your broader financial plan for the year ahead?
- Have you discussed the proposed position with a licensed financial advisor who understands your full financial picture and goals?
A clear understanding of how these contracts work is essential before deciding whether they fit into your broader investment approach, Mazzola emphasized. Reading the prospectus of any ETF or mutual fund you already own reveals how much derivative exposure sits inside your retirement accounts.
Related: Schwab warns private credit investors
