What are Equity Derivatives?

Stock market basics 101: Equity is the share of a company that you, as an investor, own. Such equity, in turn, allows you access to the gains of the company. The shares you own are also known as equity securities.

On the other hand, a derivative is a security that is an agreement signed between two or more parties to buy or sell assets in the future. Investors make gains by anticipating or estimating the future value of that asset.

There is another form of investment that is an amalgamation of the two concepts: Equity Derivatives.

What are Equity Derivatives?

The Equity shares owned by you can act as underlying assets that give their value to financial instruments called derivatives. Assets can also include bonds, commodities, and securities. The value of such financial assets depends on price fluctuations in the share market and the performance of the companies.

For example:

A stock option is an equity derivative. Why?
Its value or the share price is based on the price movements of the underlying stock. Investors use equity derivatives to hedge the risk that comes along with taking long/short positions or use them to speculate about the price fluctuations of the underlying asset.

Simply stated, the definition of equity derivatives is that they are financial instruments, the value of which is derived from the change in price in the underlying assets such as equity stocks or shares in the secondary market. Therefore, the value of the financial product is derived from the underlying equity.

When you invest in equity, you hold ownership of that portion of equity. With ownership of the investment, comes risk, and such investments show fruit in the long term. However, for short-term gains, equity derivatives are the better alternative.

When you buy equity derivatives, you are only buying the performance of the underlying asset without taking ownership or any equity of the company. The risk of making a loss reduces considerably.

Dealing with equity derivatives is not a mindless wager. It requires thorough research into a company's financial position and projections. If you do not have the knowledge or the training regarding investing in equity derivatives, we’d suggest you make use of the services of finance professionals like IIFL who can take you through the process smoothly.

What are the types of Equity Derivatives?

1. Options

   With Options, you can buy/sell shares at a particular preset price called the strike price. An options contract can be entered into for purchase (call) or for selling (put). On the other hand, there is no obligation for you–the investor, to make the trade. The option’s price typically referred to as ‘Premium’, depends on the expiry date, the strike price, and the stock’s instability. Investors use options contracts to hedge risk in the equity market.

2. Futures

   A Futures contract is made between two parties. The buyer agrees to buy and the seller agrees to sell the underlying asset (which is equities) at a contract price on a pre-specified date in the future. In a futures contract, the buyer must buy the asset. The seller is also obligated to sell on the specified future date. In other words, the buyer has to buy the asset on the date mentioned in the contract and at the specified price.

3. Warrants

   The holder of a warrant has the right to buy the underlying stock at a specific date in the future but there is no obligation to do so. Warrants are issued by companies as an incentive to those who hold preferred stock and bonds of the company.

4. Swaps

   Swaps are contracts wherein returns of two different equity stocks are exchanged between two parties. The exchange can be related to equity returns, floating and fixed interest rates, currencies of different countries, etc.

What are the benefits of Equity Derivatives?

• Managing Risk

  Equity derivatives are a great tool by which one can transfer or transform the risks associated with asset valuations. This risk shifts from risk-averse individuals to heavy-riskers in the share market.

• Protection Against Price Fluctuations

  Hedging involves investing in related securities to reduce the risk of a decline in the prices of an asset. Not only does this protect you from a fall in prices, but it also acts as a safety net against the rising prices of equity you want to or plan to buy.

• Physical Settlement

  Many investors want to retain shares for a long-term and larger gain. That does not mean they don't like the sweet fruit of short-term gains as well. This is typically achieved through physical settlement, thus allowing you to make money on idle shares.

• Arbitrage

  Arbitrage means simultaneously selling an asset in one share market and buying in another to profit from the price difference. In India, the two markets are the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). A share can be more valuable in one market than in the other.

• Margin Trading

  As an investor trading on a contract, you are only required to pay a margin and not the entire amount. By indulging in margin trading, you can maintain a high outstanding, and the gains earned from precise estimates point towards high, fast-paced growth.

Final Words

The meaning of Equity Derivatives may seem confusing at first, but once you truly begin investing in this asset, you will witness the profitability of this investment option!