Equity refers to the value of the assets minus the value of the liabilities of something owned. Simply put, equity is one’s degree of ownership in any asset, like business and property, after its debts and liability are paid. Stocks are considered as an equity since they represent ownership in a corporation.
As a traditional equity investor, you buy and hold shares of a stock on a stock market in anticipation of income from capital gains and dividends. Another way to participate in the price action of an underlying security is by using an equity derivative, a financial instrument that offer investors opportunities to benefit from an underlying security without having to own the security itself.
An equity derivative is a particular type of financial derivative that takes its value from one or more underlying equity securities. Its value fluctuates with the changes in its underlying asset’s value, which is often measured by a share price.
Why Investors Use Equity Derivatives
There are two major reasons for using equity derivatives. Firstly, you use derivatives for risk management (hedging). You can hedge against price movements and other risks associated with taking a position in a stock. In this way, you set limits to the losses incurred by either a short or long position in the shares.
Secondly, you use derivatives for speculation. Speculating on derivatives offer you a risky opportunity to make a financial bet and increase your profit.
5 Types of Equity Derivatives and How They Work
Derivatives are basically contracts that can be categorized as either “lock” or “option” products. Lock products obligate contractual parties to the term over the effective life of the contact. Option products, on the other hand, provide the buyer the right but not the obligation to buy or sell under the terms specified.
There are several different types of equity derivatives and each has its fair share of advantages and uses.
Stock options are the most popular equity derivative. Holding this derivative provides the investor the right, but not the obligation to buy (call option) and sell (put option) amount of stock at a fixed price by a specific date. Options have a price decay. Stock options derive their value from the time premium that spoils as the expiration date nears, plus the value and volatility of the underlying stock.
Call and Put
A call option provides the investor (holder) the right to buy a stock at a set price by an expiration date; A put option provides the holder the right to sell a stock at a set price by an expiration date.Stock options allow the investor to either hedge the risk or speculate by taking on additional risk. They are traded on exchanges and they’re centrally cleared. That said, they have liquidity and transparency working for them.
A warrant gives the holder the right to buy a stock from the issuer at a specific price within a certain date. It’s quite similar to options wherein investors can exercise warrants at a fixed price but unlike the previous derivative, warrants have longer lifespans. The price of a warrant is also always higher than the underlying stock price.
Single stock futures
A single stock future is a contract to deliver 100 shares of a specified stock on a designated date in the future. No share rights or dividends are exchanged.
A single stock future provides investors increased capabilities to leverage within the market. It acts like a futures contract so it can be traded on margin unlike a majority of options. Since the price derives from the price of the underlying stock, many investing strategies can be applied.
Index Return Swaps
An equity index return swap refers to the agreement between two parties to exchange or swap two sets of cash flows on predetermined dates over an agreed quantity of years. It allows investors to structure a swap to spread out capital gains over a prespecified number of years in exchange for paying interest at a fixed rate; One party may pay the interest while the othe party pays the return on an equity or equity index.
Investors seeking to gain exposure to a certain security or asset class use swaps. The major downside is that, when the index turns against you, it may be difficult to get out of the swap.
Contract for Difference (CFDs)
The difference between where a trade is entered and exited is called the contract for difference (CFD). Essentially, it is the agreement between the client and the broker, who are exchanging the difference between the current value of a share, commodity, currency, or index, and its value when the contract ends. A CFD is a tradable instrument that moves in relation to the position taken, thus allows the investors to speculate on the price movements of their underlying stock without needing them to own the shares.
One of the main advantages of CFDs over stock options is their pricing simplicity. They also have a wider range of underlying instruments. They do not have an expiration date, so they have no decaying premiums. The major risk, however, is the counterparty risk wherein the other party in the contract fails to meet their obligation. They also provide a higher leverage, which can either be a blessing or a curse.
Author Bio: Sophie Harris is one of the resident writers for FP Markets, a CFD and Forex Trading provider in Australia with over 12 years industry experience serving global clients. Writing informative content about business and finance is her cup of tea.