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What Are Equity Derivatives and Their Different Types?

The equity derivatives are one of the most interesting ways to trade equities.

Primarily the word derivatives refer to any contract between a buyer and a seller.

In case of derivatives, the value is derived from an underlying asset.

This underlying asset can include anything from bonds to commodities.

You even have derivatives based on interest rates or key stock indices.

When the equities derive the underlying value, they call it an equity derivative.

An equity derivative is part of advanced investment opportunities in the market.

They are mainly seen as speculation and hedging options.

Essentially investors try to take advantage of the price changes in the underlying asset class.

The derivative is always traded as a futures contract.

So, if you anticipate a fall in certain stock going forward in future, you can easily take up equity derivatives to get the advantage.

The relatively lower risk profile often attracts investors to derivative contracts.

Compared to conventional equities, these derivatives spread out the risk associated.

The risk is in fact, is divided between the two parties.

There are many different types of equity derivatives.

Here is a quick look at them.

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Understanding Stock Futures

This is one of the most basic kinds of equity derivatives.

They also know is as Single stock future.

Most times it involves a pack of 100 shares of a stock allocated on a future date.

The price of these stock futures is a combination of multiple elements.

Of course, the biggest part is derived from the value of the underlying equity.

That apart, there is also the interest cost and potential dividend payment.

By combining these three elements, you can estimate the future price.

Normally trading in these single stock futures needs a relatively lower margin.

This again compares with the actual underlying equity.

Normally for conventional stocks, investors pay about 20% margin to buy.

It goes without saying that the lower margin gives investors greater leverage.

They are able to invest in larger sums.

They can also invest in a wider range of futures.

Moreover, there are no restrictions for day traders in this case.

You can trade them using almost strategy that you employ for regular stocks.

More often than not, they reflect the prices tick by tick.

This means any strategy that is effective in regular equity trade will be equally effective.

There are many reasons why you might want to invest in a stock future.

This is an equity derivative that helps you take advantage of the time difference.

It helps you hedge open positions in the stocks.

But investors do not have to pay a huge premium for the open position.

It becomes a cost-effective means to hedge investments.

But at the same time, investors must be prepared to brace up for losses.

The losses can at times exceed that of the actual stock price.

But you have the time advantage.

So investors can surely make use of that to book profit in time.

What Are Stock Options?

When you take equity derivative into consideration, stock options are also immensely popular.

This is because stock options are all about maximizing profit at minimum risk.

If you are wondering how, well it is rather simple.

This is because, in case of stock options, investors have no obligation to buy or sell.

While they do have the right to do so and hedge risk, there is no compulsion.

In fact, investors who already own a particular share can take advantage of the price difference through options.

The price, therefore, is closely linked to the expiry date.

The volatility of the stock movement also affects this pricing to a large extent.

The higher the rate of volatility, the bigger the premium.

The option buyer will have to shell out this additional amount while investing in them.

For the option seller, this means the extent of profit will be that much higher.

But investors don’t have to scamper and square off position as expiry dates near.

Moreover, stock options trade on established exchanges.

This means there are absolute transparency and clarity in their operation.

It also cuts down the risk of frivolous players.

Invariably only serious investors with proper business acumen invest in these.

Therefore, the price discovery also happens at a much better rate.

The relative risk in stock options is considerably higher.

But the higher premium and profit potential also acts as an incentive.

This is exactly why this is a popular hedging option.

Investors can easily take up positions based on their overall risk appetite.

The lack of any buying or selling obligation also makes for greater flexibility.

Investors can fashion strategies that maximize profit.

But at the same time, this also makes sure that they can brace against losses better.

Insight into Warrants

In many ways, options are similar to warrants.

Just like in options, users have the right but no obligation to buy or sell.

When the contract comes close to the expiry date, they are not under any undue pressure to buy or sell the underlying stock.

But this is exactly where the similarity between this equity derivative and options end.

While the investors initiate the stock options, they do not initiate the warrants.

The owner of the company invariably issues the warrants.

Normally all those investors who have company bonds or preferred shares are eligible.

Investors can either buy Call warrants or sell put warrant at a specific price.

The price is most times significantly higher than the existing stock price.

This, therefore, gives them the incentive to invest in these warrants.

One of the key reasons that companies issue warrant is improving the bond yields.

When investors do exercise these stock warrants, the company has to issue new shares.

These additional new shares help the company cover the existing transaction.

Though stock warrants are available on exchanges, there are some liquidity concerns.

These warrants invariably normally have very low volumes

This means that there is a relative liquidity risk in them.

However, just like options, the price of these decline as the expiry date approaches.

This is one of the most important risks for the warrant investor.

If the underlying stock price does not reach the warrant price by expiry date, this equity derivative becomes null and void.

Therefore the price of the underlying stock is the key monitorable in this case.

As the warrant nears expiration, all eyes are on this price.

If the actual stock price is unable to escalate, there is the risk to lose the entire investment.

Contract for Difference

Another popular equity derivative is contract for difference.

Normally this is a contract between a seller and a buyer like all other derivative contracts.

The difference between the stock price after placing the contract and the current level determines the value of the contract.

If this difference gets into the negative zone, the buyer pays the seller.

The reverse happens if the difference goes in opposite direction.

The purpose of this equity derivative is same as most others.

Investors get an opportunity to play on the price difference without owning actual shares.

They can speculate on the price movement without the risk of ownership.

However, these contracts for difference are not easily available in all markets.

In the United States, an investor cannot take advantage of this equity derivative.

But many European and Asian stock markets provide this option.

Markets in France, Germany, United Kingdom, Japan, Singapore are among the front-runners.

The biggest advantage of these contracts is undeniably the simplicity in pricing.

This is because they do not have any expiry dates associated with them.

No expiry date means there is no price erosion or value enhancement with respect to expiry.

So the only determinant is the price of the underlying stock.

However, the higher leverage also means higher loss prospects.

Therefore, investors need to be very cautious while executing this trade.

They must undertake a complete assessment of the price movement to fully take advantage.

The loss, in this case, is also referred to as counterparty risk.

This means that when the counterparty is unable to honor their part of the obligation.

The investor essentially then becomes a victim to a margin call.

On the whole, any sudden movement in the underlying stock can spell trouble.

It can immediately affect the overall profit-loss ratio of the stock.

Index Swaps

This is another interesting equity derivative in the market.

As in case of other derivative contracts, this is also an agreement.

In this case, there could be two different assets in consideration.

The cash flow between the two forms the profit-loss component.

For example, let us say you have some position in S&P 500 derivatives.

Now the return on this is pegged on the basis of return from some other stock derivative.

There is a distinct advantage of this type of dealing.

It cuts down the relative transaction cost involved in trading stocks for money.

The cash flow, in this case, is, however, at par with the money they would get through conventional buy and sale of stocks.

This particular investment vehicle is commonly used by active money managers

They constantly increase or decrease exposure through these swaps.

This means while the stock exposure is up to their target, the cash outflow is lesser.

Often fund managers swap existing stock shares for entire Index units.

This kind of swap settlement also has a distinct tax advantage.

Depending on their exposure, investors can chalk out a swap.

In this case, they would then spread out their gains over a certain number of years.

However, the interest payment, in this case, will be at a fixed rate.

These payment terms are also based on the share swap agreement.

However, there is also some risk associated with it.

If the share price of the stocks you exchanged comes down, it is difficult to get out of it.

In that case, you are stuck with the stock futures with depreciated value.

Of course, the relative risk-reward ratio is based favorably.

This is the worst case situation.

But investors must carefully consider this to fully take advantage of the price advantage.

Advantages of Equity Derivatives

There are many advantages of trading in equity derivatives.

1. Arbitrage Advantage

This is one of the biggest triggers for equity derivative trade.

The investors get an opportunity to take advantage of the price difference.

The difference in price is generally between the current price and the price at a future date.

The price of the underlying equity is taken into consideration in this case.

Normally the price of the underlying asset holds maximum share in the overall value of the derivative.

In case of equity derivatives, investors can also take advantage of the price difference between two exchanges.

2. Distributing Risk

The risk in case of equity derivative is divided into both holders of a contract.

Whether you are the buyer or the seller, the contract risk is equally distributed.

Moreover, this instrument transfers the risk from owning actual assets.

So the overall risk component is much lesser in this case.

Investors who are heavily leveraged in the market can use it as a protective shield.

This helps them to maintain a relatively balanced portfolio and manage risk.

The overall price volatility is also managed efficiently.

3. Price Volatility

This is another major trigger for owning equity derivatives.

This is a unique opportunity for investors to hedge positions.

It allows them to cut down or limit the risk of a potential slide in prices.

Therefore, this investment channel effectively reduces the impact of adverse price movement.

In many ways, it becomes the investor’s safety net.

4. Advantage of Margin Trading

More than investors, this is a big advantage of day traders.

When they take a position in a derivative contract, they only pay a margin of the price.

The actual amount can be very huge.

So they take advantage of the underlying stock’s share price movement without paying the actual price.

They are pretty much trading on sidelines.

Disadvantages of Equity Derivatives

However, equity derivatives have some disadvantages too.

1. Varying Dividend Rate

You must remember that as an investor, you cannot control the dividend rate.

The shareholder does not have any say in this matter.

The company management becomes the sole decision maker.

They determine the amount of dividend that needs to be paid.

So, investors do not have the comfort of earning steady dividend income.

2. Price Fluctuation

In case there is an adverse price movement, investors would clock losses

Though they own only derivative contracts, adverse movement in actual price can affect derivative market rates also adversely.

Also as the expiry date nears, it could lead to severe price erosion.

For example, in case of warrants, the share price needs to escalate to warrant rates.

If that does not happen, it could lead to the complete value of the warrant nullifying.

This can mean that the entire premium paid initially goes waste.

The investor has to settle for a loss.

3. Timing Trades

That brings us to the next big concern in derivative trading.

In most derivative contracts, there is definitive expiry date.

Inevitably the value of the contract keeps eroding as the expiry date nears.

So if you have not already squared off your positions well in time, it is a major risk.

The investor can even land up with no profit.

They can even slip into the negative zone.

So though there isn’t the direct risk of value erosion, the trade has to be timed well.

Miscalculation of value can lead to severe value erosion.

Various Approaches to Make Profit

Therefore, we can conclude that the different types of equity derivatives are various approaches to make profit.

Just like any other investment instrument, they also carry a certain amount of risk.

Investors need to be practical and prudent while taking up position.

They must understand the overall risk-reward potential completely.

This will help them take advantage of the benefits more than the gains.

The key, in this case, is transferring the risk at an opportune moment.

This will ensure that they are able to take advantage of the profit without leveraging unduly.

However, before owning even a single contract, investors must educate themselves into the various nuances of derivatives trade.

Compared to simple share buying and selling, this is a rather complicated procedure.

It entails advanced learning and thorough assessment of the various market components.

If investors are not able to anticipate the risk involved, they can clock severe losses in these trades.

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