What are Equity Derivatives?

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Equity derivatives are derivatives whose underlying assets are equities and equity indices. Investors and traders use equity derivatives for various objectives, including risk management, speculation, and portfolio optimization. Derivatives allow traders to speculate and trade on the direction of an underlying asset's price movement without owning it. 

Equity Derivatives Meaning

Equity derivatives are financial instruments whose value is based on the price movements of stocks or shares. These derivatives, such as options and futures, allow investors to speculate on or hedge against the fluctuations in the value of individual stocks or stock indices without owning the underlying assets.

Investing in equity means owning a share of the company. This equity gives you access to the company's gains. So, equity derivatives refer to the equity shares you own that act as underlying assets for a financial contract. Securities, commodities, and bonds can also be considered assets. Moreover, share market fluctuations and the performance of companies determine the value of such financial assets. After learning the definition of equity derivatives, let’s move on to their types.

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Types of Equity Derivatives

So, after understanding what equity derivatives are, here are the four types of equity derivatives:

  1. Options

    Options let you 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, you 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.

  2. 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.

  3. Forward

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

  4. 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.

Advantages and Disadvantages of Equity Derivatives

Here are the advantages and disadvantages of equity derivatives:

Advantages of Equity DerivativesDisadvantages of Equity Derivatives
- Risk Management: Shifts risk from risk-averse individuals to market risk-takers.- Liquidity: Varying liquidity across derivatives, making urgent liquidation challenging.
- Protection Against Price Fluctuations: Hedging to minimize asset price risk.- Leverage: Potential for amplified gains but also magnified losses.
- Physical Settlement: Allows for short-term gains while holding shares for long-term profits.- Contract Holder: Derivative traders do not directly benefit from corporate actions.
- Arbitrage: Exploiting price differences between different stock markets.

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- Margin Trading: Margin trading allows for higher outstanding positions.

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Risks Associated with Equity Derivatives

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 extremely 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 danger 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?

Trading in equities derivatives is appropriate for individuals familiar with the derivatives market and the risks associated with stock market volatility. Traders in the derivatives market should have a well-defined investing strategy as well as a risk-management approach. Equity derivatives can help traders, institutional investors, and those seeking portfolio diversification or hedging against market volatility. To reduce risks, novice investors should obtain expertise in regular stock investments before moving on to derivatives or seeking professional guidance. 

Conclusion 
An equity derivative is a financial instrument whose value derives from an underlying equity asset. They help investors manage their risks and participate in the stock market. You need to understand the definition, types, benefits, and drawbacks of successful derivative trading. The upside of equity derivatives is risk management, price fluctuation protection, and profits. 

However, there are also downsides, like liquidity issues, leverage risks, and limited participation in corporate actions. Using an app like the BlinkX trading app, investors can trade equity derivatives in a user-friendly and efficient way.

Equity Derivatives FAQs

Value or price is the main difference between derivatives and equity. The value of equity is determined by market conditions such as demand and supply, as well as company and economy related events. Alternatively, a derivative is derived from an underlying asset such as an index, stock, currency, etc.


 

In an equity derivative, an investor buys only the performance of the underlying investment without taking ownership of the company's stock. Moreover, equity options present much lower risks than stock ownership.

The investor must be highly knowledgeable about the equity derivative product and industry to trade it since derivatives allow for speculation and large gains or losses. Risks associated with equity derivatives include interest rate, currency, and commodity price risks.


 

The five popular derivatives are options, futures, warrants, contracts for differences, and swaps.

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