Equity Derivatives: Meaning, Benefits and Risks

In derivatives trading, there are various types of securities whose value is derived from  price movements of underlying assets. They can include equity, commodities, currencies, and a lot more. 

In this blog, you will get an in-depth idea of equity derivatives, their pros and cons, and more. Keep reading! 

What Are Equity Derivatives?

Equity derivatives are financial contracts that have stocks and indices as their underlying assets. They are mainly used by traders for hedging their investments against volatility and speculating price movements in order to generate returns. 

These assets are excellent for investing in the short term as unlike equities, investors do not have to wait for a long time in order to realise profits. Furthermore, they also do not need to have large funds to purchase a company’s stocks. 

Types of Equity Derivatives Contracts 

The types of contracts that you can use for trading equity derivatives are as follows:

• Options

Options are financial contracts that give you a right but not an obligation to buy or sell an underlying asset at a pre-decided price and date of expiration. This agreement comes in two types – call option and put option. 

The call option provides you with the right to purchase the underlying asset and the put option gives you the right to sell it at the prefixed value and date. The former is generally used when there is an anticipation of a price rise, while the latter is preferred when there is an anticipation of a price fall. 

To enter the contract, the buyer pays a premium to the seller and upon exercising his/her right, the seller must settle the option based on the agreement terms. 

• Futures

Futures are derivative contracts that give you the right as well as the obligation to buy or sell an underlying asset at a pre-set value and date of expiry. In order to enter this contract, you have to pay a margin amount to your broker and upon expiry, can settle the transaction via a cash settlement or delivering the asset.  

• Warrants

Warrants are derivative agreements that provide you with the right but not the obligation to purchase or sell an underlying asset at a specified strike price and expiration date. Their working is similar to options contracts. They are executable before or on the expiration date and provide the rights to buy and sell the underlying security called call and put warrants.

However, unlike options, they are traded Over The Counter (OTC) and have a maximum investment duration of 18 months. 

• Swaps

A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. . This transaction can be based on equity returns, foreign currencies, fixed and floating rates of interest, etc. 

Currency swaps and interest rate swaps are the most frequented types in the derivatives market and they are mainly traded Over the Counter.  

Advantages of Investing in Equity Derivatives

Here are some of the advantages of equity derivatives investments:

• Low Investment Costs

A significant benefit of equity derivatives is that they come with low investment costs. On one hand, these contracts are much cheaper than their underlying equity stocks and on the other, you get to use leverage in order to expose yourself to larger transactions. 

Thus, by paying a low investment amount, you stand the chance to earn a significant amount of profit.  

• Arbitrage

An arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Through equity derivatives, you also get the benefit of arbitrage trading. You can take advantage of the asset’s price difference in the stock market in comparison to its value in the equity derivatives market.  

• Protection From Volatility

You can protect your investments from stock market fluctuations by using a hedge. As these investment vehicles generate similar returns to their underlying asset, you can take the help of the call or put option to prevent potential losses. 

Disadvantages of Investing in Equity Derivatives

These are some of the disadvantages of investing in equity derivatives:

• High Volatility

In the case of equity derivatives, high volatility is a risk that you must consider before investing. The underlying stock’s value may fluctuate regularly and can cause potential losses if the correct investment decisions are not taken. As derivative contracts are leveraged products, high volatility can cause huge losses and even wipe out your entire investment corpus.    

• Market Risks

The equity market depends on a lot of factors for its performance. Global geopolitical events, interest rate changes, recessions, etc. can affect the entire market as a whole, causing downward price movements for all stocks. As equity derivatives obtain their value from underlying stocks, this is a huge risk that you must consider before investing in this asset. 

• Counterparty Risks

Not all types of equity derivatives contracts are liquid on the stock exchanges. Agreements like warrants and swaps are traded privately among parties, i.e. Over the Counter. Thus, there is a chance of counterparty risks or participants not holding their end of the bargain. 

So, before trading equity derivatives contracts over the counter, this is a risk that you must take into account.  

What Is the Difference Between Direct Equity and Equity Derivatives?

Here are some of the key differences between direct equity and its derivatives counterparts:

• Investment Horizon

When you invest in direct equity, you can select a tenure depending on your investment goals. You can hold the stocks in your portfolio for the short term or long term and sell them off when you see chances of profit. 

However, equity derivatives contracts have a fixed expiration date attached with them. 

• Factors Affecting Value

The value of direct equity depends on several factors like demand and supply, future growth potential, competition in the current market, and more. But, in the case of equity derivatives, the contract value depends on the price movements of their underlying assets and certain other factors like volatility.   

Final Words

Before you invest into the equity derivatives market, it is recommended that you gain a clear understanding of the nuances of the market. This way, you will have an idea of what challenges you may face and take the appropriate decisions in order to make profitable trades. 

Frequently Asked Questions