What are Equity Derivatives?

Equity derivatives are financial contracts whose value is derived from an underlying equity instrument, such as an individual stock or a stock market index. These instruments do not involve direct ownership of the underlying shares. Instead, their pricing and performance are determined by movements in the underlying equity market. The main objective of using equity derivatives in the stock market is for risk management and trading purposes. They help investors hedge against price fluctuations, manage portfolio exposure, and take positions based on expected market movements in a structured and regulated manner. This article provides an overview of what is equity derivatives by explaining their types, advantages, and disadvantages. 

Types of Equity Derivatives  

After understanding equity derivatives meaning, this section discusses the types of equity derivatives. There are four main types of equity derivatives.  

Options 

Options let investors buy/sell shares at a set price called the strike price. It is possible to enter into an options contract to purchase (call) or sell (put). However, as an investor, they are not obligated to make the trade. An option's premium is determined by the expiration date, the strike price, and the stock's instability. In the equity market, options contracts are used to hedge risk. 

Futures 

A futures contract involves two parties. At a pre-specified date in the future, the buyer and seller agree to purchase or sell the underlying asset (which is equity) at a contract price. However, when a futures contract is entered, the buyer is legally obligated to purchase the asset. A seller must also sell on the future date specified in the contract. To put it another way, the buyer must purchase the asset on the date and at the price specified in the contract. 

Forward 

Forwards are similar to futures in that both parties are bound to execute the contract. Conversely, forwards are non-standardised, over-the-counter transactions that do not trade on stock exchanges. 

Swaps 

In swaps, the returns of two equity stocks are exchanged between two parties. Exchanges can be related to equity returns, floating and fixed interest rates, currencies of different countries, and so on. 

How are Equity Derivatives Traded? 

Having understood equity derivatives meaning and their types, here’s a step-by-step guide on how equity derivatives trading is done by traders.  

Step 1: Select the Equity Derivative Type 

Depending on the purpose, either to hedge, to speculate, or to earn an income, investors can choose whether to trade in equity futures, equity options, or index derivatives (Nifty/Bank Nifty, etc.).  

Step 2: Choose the Underlying Equity Instrument  

Choose the stock or stock index that the derivative contract is constructed on. The price of the derivative will follow this underlying instrument. 

Step 3: Check Contract Details Before Placing a Trade 
Review key contract specifications such as: 

• Expiry date (weekly/monthly) 
• Lot size (fixed quantity per contract) 
• Strike price (for options) 
• Contract type (Call/Put for options; Buy/Sell position for futures) 
• Market price/premium (for options) or futures price 

Step 4: Ensure Margin Availability in the Trading Account

For futures and many option positions, investors need to maintain margin as per exchange/broker rules. Margin requirements depend on volatility, lot size, and the type of position investors take. 

Step 5: Place the Trade Order

Place an order through the broker’s platform: 

• Choose Buy or Sell 
• Select order type (Market/Limit/Stop-loss) 
• Enter quantity in lots 
• Confirm and place the order 

Step 6: Monitor Position and Manage Risk during the Trade 

It is important to track the price movement of the underlying and the derivative contract. Use risk controls like: 

• Stop-loss orders 
• Position sizing 
• Hedging with opposite positions (if required) 

Step 7: Decide How Much to Close or Settle the Trade 

Investors can easily exit in three common ways: 

• Square off before expiry: Close the position by taking an opposite trade. 
• Hold till expiry: The contract is settled as per exchange settlement rules. 
• Exercise options (if applicable): In-the-money options may be exercised depending on the type of option and settlement process. 

Step 8: Final Settlement and Charges are Applied 

Once the position is closed or expires, the final profit/loss is credited/debited, and applicable charges are deducted (brokerage, exchange fees, STT, GST, stamp duty, etc.). 

How Equity Derivatives Work  (Example Options) 

Equity derivatives derive their value from an underlying equity instrument, such as a company’s stock. Options are a common equity derivative where the contract’s price moves in line with changes in the underlying share price. 

As an illustration, suppose ABC Ltd. is trading at ₹1,000 on the stock market. There is a call option with a strike price of ₹1,050, a one-month expiration date, and a premium of ₹20 per share. The buyer has the opportunity, but not the obligation, to buy shares of ABC Ltd. at ₹1,050 on or before the expiration date. 

If the share price of ABC Ltd increases to ₹1,100 prior to expiry, the option gains value as the buyer is able to acquire the shares at ₹1,050 and subsequently sell them in the market for a higher price. In this scenario, the intrinsic profit amounts to ₹50 per share, and after accounting for the premium paid, the net profit is ₹30 per share. This increase in option value occurs solely due to the rise in the underlying stock price. 

On the other hand, if share prices stay below ₹1,050 at expiry, the option becomes worthless. The buyer loses ₹20 per share, which is the premium, while the seller keeps the premium as profit. This shows how the worth of options, and equity derivatives as a whole, is connected to the movement of the underlying stock, not the contract. 

Uses of Equity Derivatives 

The following are the uses of equity derivatives trading.  

• Hedging price risk: Equity derivatives are used to protect portfolios against adverse price movements in stocks or stock indices by offsetting potential losses. 
• Speculation and trading: Traders use equity derivatives to take positions based on expected price movements without buying or selling the underlying shares directly. 
• Leverage: Compared to direct equity investment, equity derivatives allow investors to get exposure to stocks with a comparatively lower capital investment.  
• Portfolio diversification: Investors can more effectively control overall portfolio risk and diversify strategies by using derivatives on several equities or indices. 
• Income generation: To generate regular premium income, some option strategies are used, such as writing call or put options. 

Advantages and Disadvantages of Equity Derivatives 

The table below shows the advantages and disadvantages of equity derivatives. 

Risks Associated with Equity Derivatives 

After understanding what is equity derivatives market, this article further explores the risks associated with them. Here are the risks associated with equity derivatives: 

Leverage risk: Equity futures frequently employ leverage, which implies that a little price change in the underlying asset can result in large gains or losses. While leverage can increase earnings, it can also increase losses, perhaps outweighing the initial investment. 

Market risk: Equity derivatives are typically sensitive to fluctuations in the underlying asset price. Market risk encompasses the risk of adverse price fluctuations, volatility, and unanticipated market occurrences, all of which can influence the value of derivative contracts. 

Counterparty risk: Counterparty risk exists in over-the-counter (OTC) derivative markets. If the other party in the deal fails to meet their obligations, the investor may incur considerable losses. Trading on regulated exchanges can help to reduce this risk. 

Liquidity risk: While main equities derivatives markets are liquid, individual contracts or less popular assets may be insufficiently liquid. Because of illiquidity, it might be difficult to execute deals at targeted pricing, potentially resulting in losses. 

Time decay: Options contracts have finite lives, and their value deteriorates with time, owing mostly to time decay. This provides a risk for option buyers, who may see the value of their holdings drop even if the underlying asset's price stays steady. 

Regulatory risk: Government rules and tax laws governing derivatives are subject to change, which affects how these instruments are traded, taxed, and reported. Investors must remain up to date on regulatory developments that may influence their investments. 

Psychological stress: Trading in stock derivatives may be emotionally demanding owing to the possibility of large losses and market volatility. Emotional responses might result in rash judgments and poor risk management. 

Risk of complexity: Derivative products can be complicated, necessitating a thorough grasp of pricing theories and tactics. Investors who do not completely understand this complexity run the risk of making expensive errors. 

Margin calls: Investors who use leverage may be obliged to meet margin calls if their investments move against them. Positions may be forcibly liquidated if margin requirements are not met. 

Who Should Invest in Equity Derivatives? 

The following are some individuals who can invest in equity derivatives.  

1. Experienced Market Participants 
   Equity derivatives are suitable for investors and traders who have a clear understanding of stock market movements, derivative pricing, and associated risks. 
2. Investors Seeking Risk Management 
   Those holding sizeable equity portfolios may use equity derivatives to hedge against short-term market volatility or downside risk. 
3. Active Traders with Defined Strategies 
   Traders who follow disciplined trading strategies and actively monitor the markets may use equity derivatives for short-term trading opportunities. 
4. Investors with Higher Risk Tolerance 
   Equity derivatives are appropriate for individuals who can tolerate price fluctuations and potential losses arising from leveraged positions. 

Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions. 

Conclusion 

Equity derivatives serve the purpose of hedging risk, capturing value from price movements, and managing portfolio exposure from underlying equities or stock indices. Their value comes from the underlying asset that can offer greater portfolio management and risk exposure. However, volatility, margin requirement, complexity, and time decay must be understood. Equity derivatives are mostly accessed, monitored, and managed via a stock market trading app, which offers real-time pricing, contract information, and position tracking.