What is Equity Derivative?
The term “equity derivative” refers to the financial instruments whose value is determined on the basis of the price movement of the underlying asset, which is equity in this case. Typically, investors use these financial instruments for hedging risks associated with long or short positions in equity stocks. Equity derivatives are also used for speculating the price movement of the equity stock.
Explanation of Equity Derivative
For investors, equity derivatives are just like insurance policies for protection against an adverse movement in equity stocks. In case the equity stock goes south due to any reason, the investors are guaranteed a minimum payout in exchange for the cost of the derivative instrument, which is the option premium. Further, equity derivatives are also used by investors for speculative purposes.
How to Trade Equity Derivative?
A trader needs to follow the below-mentioned steps for trading in equity derivatives:
- It is very important to do the research first to understand the derivatives market. Please note that the strategies to be used for the derivative market may be entirely different from that of the equity stock market.
- Set-upa margin amount as the stock market mandates the maintenance of the required margin amount at any point in time. So, the trader can’t withdraw this particular amount from the trading account until all the positions are settled.
- Ensure that the account allows trading in equity derivatives. After that, go ahead and execute all the transactions through the trading account.
- Choose and trade inequity derivatives based on the amount available in the trading account, margin requirement, price of the underlying equity stock, and premium of the derivative contracts.
- The trader can either exit the contract before its expiry by placing a ‘sell trade’ future contractor to wait to settle the trade at the time of its scheduled expiry.
Examples of Equity Derivative
Now, let us look at some of the common examples of equity derivatives.
Example #1
Let us assume that David bought 20 equity shares worth $15 each for a total of $300. He also purchased 20 put options for at $1 each at the strike price of $18, which means the total cost of the put options is$20 (= $1* 20).
So, if the share price increases beyond$18, then David can sell the shares in the equity market and let go off the put options unexercised. However, if the price fails to reach $18 or falls further below the current market price of $15, then David can exercise the put options and book profits.In this case, the minimum profit is guaranteed due to the put options while the upside is unlimited if the share price goes beyond $18.
Example #2
Let us assume that John currently holds 2,000 shares of XYZ Inc. worth $100,000 ($50 per share) and he intends to sell them off after 90 days. However, given the volatility of share price he is not sure whether he would able to sell them off profitably at that time. So, he decided to enter into a forward contract with an interested buyer to sell the shares exactly after 90 days at the determined price of $55 per share.
Now, at the end of 90 days, John will be obligated to deliver the shares or make cash settlement irrespective of the market price of the company shares. So, in this case, John’s profit for the future date is already decided today and it won’t change under any market scenario.
Types of Equity Derivative
There are four major types of equity derivatives and they are – options, futures, warrants and swaps.
- Options: It provides investors the right (but not obligation) to purchase or sell equity stock at a particular pre-determined price, which is referred to as the strike price of the option contract. Typically, an option contract states the type of option (call or put), option premium, number of shares, strike price, and expiry date of the contract.
- Futures: It refers to the contract between two parties – seller and buyer, wherein the seller agree to sell and the buyer agrees to buy the underlying equity stocks at a pre-determined price on a pre-decided date in the future. Please note that future contracts amount to an obligation on the part of the seller and the buyer to honor the contract.
- Warrants: These equity derivatives are issued by the companies for their existing investors (through equity stocks or bonds) wherein it grants them the right (but not to obligation) to purchase the underlying stock on a specific date in the future at a pre-determined price, which is usually lower than the market price.
- Swaps: In this case, two parties enter into an agreement to exchange their cash flows either in the form of an equity index swap or simply equity swap. These financial instruments allow the investors to hedge the specific assets or positions in their investment portfolio while still holding the original assets.
Advantages
Some of the major benefits of equity derivative are as follows:
- It is primarily used to hedge the risk exposure and limit the losses in case of any adverse movement in the value of the underlying asset.
- It distributes the portfolio risk between the securities and the derivative instruments.
- The derivative contracts are available at a relatively lower cost given the amount of risk that they cover.
- The spot price of future contracts can be used to determine the approximate price of the underlying securities.
- It facilitates the enhancement of market efficiency.
Disadvantages
Some of the major disadvantages of equity derivative are as follows:
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- Sometimes equity derivatives are purely used for speculative purposes, wherein any unreasonable speculation can lead to huge losses.
- Given that derivative instruments are usually entered over the counter, it is always exposed to the risk of default by the counterparty.
Conclusion
So, it can be seen that equity derivatives are insurance policies for the equity investors and its value is driven by the value of the underlying securities. Nevertheless, it is still important that the investors make a well-informed decision as otherwise, it can result in significant losses.
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