5 Equity Derivatives And How They Work

By Hans Wagner AAA

Equity derivatives offer retail investors another way to participate in the price action of an underlying security. The value of an equity derivative comes, at least in part, from the value of the underlying security. Investors who trade in equity derivatives seek to transfer certain risks associated with the underlying security to another party. Not surprisingly, there are many equity derivatives traded throughout the world. Here we look at five equity derivatives and explain how they work.(For a background reading, see The Barnyard Basics Of Derivatives.)

1. Stock Options
Stock options, the most popular equity derivative, provide investors a way to hedge the risk or speculate by taking on additional risk. Holding a stock option provides the right, but not the obligation, to buy (call options) or sell (put options) a quantity of stock at a set price by an expiration date. Since they are traded on exchanges and centrally cleared, stock options have liquidity and transparency working for them, two important factors when considering equity derivatives.

The primary factors that determine the value of an option are the time premium that decays as the option approaches expiration, the intrinsic value that varies with the price of the underlying stock, and the volatility of the stock. Time premium decays exponentially as the option approaches the expiration date, eventually becoming worthless after that date. The intrinsic value is the amount an option is in the money. When the stock price climbs, the intrinsic value of an in-the-money call option will rise as well. Intrinsic value gives option holders added leverage over owning the stock itself. The higher the volatility of the stock the greater the premium an option buyer must pay to own the option. Of course, this provides the option seller with higher income potential if they sell an option at the peak of its volatility.

Using these characteristics, stock option investors have a number of strategies available to them depending on their tolerance for risk and the return they seek. An option holder risks the entire premium they paid to acquire the option, but they are not subject to the risk if the underlying stock moves against them. On the other hand, an option writer (the seller of an option) takes on a higher level of risk. For example, if you write an uncovered call, you face unlimited potential loss since there is no cap on how high a stock price can rise. The writer of the option would be required to provide the shares should his option be exercised.

There are a number of strategies available to options investors that blend buying and selling options to create a position that meets the goals of the investor. These strategies can include the underlying stock as well. (To learn more, see 10 Options Strategies To Know.)

2. Single Stock Futures
A single stock future (SSF) is a contract to deliver, in most cases, 100 shares of a specified stock on a designated date in the future. The market price of SSFs is based on the price of the underlying stock plus the carry cost of interest minus any dividends paid over the term of the contract. By locking the interest rate into the price of the contract, you know the carrying cost in advance.

Trading SSFs requires a lower margin than the underlying stock as investors typically use a 20% margin to buy them. The lower margin gives investors more leverage than they would get trading stocks.

SSFs are not subject to day trading restrictions or to the uptick rule for short sellers.

Since the price of a single stock future tends to track the price of the underlying stock tick for tick, any investing strategies you use for stocks can be applied to single stock futures as well. Speaking of strategies, here are some examples of how investors can use SSFs:

  • An inexpensive way to purchase a stock when you wish to take delivery of the shares to add to your portfolio;
  • Create a cost effective hedge for open stock positions;
  • Protect a long equity position against volatility or the short-term drops in the price of the underlying stock;
  • Set up long and short pairs that provide you exposure to a market situation you want to exploit;
  • Use sector SSFs that match targeted industries to gain exposure to specific economic sectors.

Investors who trade SSFs should understand that these contracts could result in losses that may substantially exceed an investor's original investment. Moreover, unlike stock options, many SSFs are not traded actively, creating potential liquidity problems. (Learn more in Surveying Single Stock Futures.)

3. Warrants
Stock warrants are rights to buy a stock at a certain price until a predetermined date. Similar to call options, investors can exercise stock warrants at a fixed price. When issued, the price of a warrant is always higher than the underlying stock price. The major difference is that stock warrants normally have a long-term time limit before they expire, such as five or even 15 years.

When an investor exercises a stock warrant, the company issues new common shares to cover the transaction. This is different from call options, where the call writer must provide the shares should the call option be exercised.

Normally you can find stock warrants trading on an exchange, although the trading volume can be low, creating some liquidity risk. Like call options, the price of a warrant includes time premium that decays as it approaches the expiration date. This creates a warrant holder's primary risk. Should the price of the underlying stock not reach the exercise price before the expiration date, the value of the warrant expires worthless. (For a more detailed description, check out What Are Warrants?)

4. Contract for Difference
A contract for difference (CFD) is an agreement between a buyer and a seller stipulating that the seller will pay the buyer the difference between the current value of a stock and its value when the contract is made. If the difference turns out to be negative, the buyer pays the seller. The purpose of a CFD is to allow investors to speculate on the movement of the price of the underlying stock without having to own the shares.

CFDs are not available to investors in the United States. They are, however, available to investors in a number of other countries including Canada, France, Germany, Japan, the Netherlands, Singapore, South Africa, Switzerland and the United Kingdom.

The primary advantage of CFDs over stock options is their pricing simplicity and the range of underlying instruments. For example, option pricing incorporates the time premium that decays as it nears expiration. CFDs only reflect the price of the underlying security. Because they do not have an expiration date, there is no premium to decay.

The primary risk of CFDs is the risk that the other party in the contract is unable to meet their obligation; this is known as counterparty risk. Investors use margin to trade CFDs, subjecting the investor to margin calls should the value of the portfolio fall below the minimum level. Profit and loss on CFD trades take place when an investor executes a closing trade. Since CFDs can employ a high degree of leverage, investors can lose money quickly should the price of the underlying security move in the undesired direction. As such, investors should be careful when using CFDs. (To learn more about these derivatives, see Instead Of Stocks, Trade A CFD.)

5. Index Return Swaps
An equity index return swap is an agreement between two parties to swap two sets of cash flows on pre-specified dates over an agreed number of years. One party could agree to pay an interest payment - usually at a fixed rate based on LIBOR - while the other part agrees to pay the total return on an equity or equity index. Investors, who are seeking a straightforward way to gain exposure to an asset class such as an index or sector portfolio in a cost efficient manner, use swaps.

Active managers use swaps as an efficient way of increasing or decreasing their exposure to different markets over time. Fund managers who seek exposure to an index have several alternatives to pursue. First, they could buy the entire index such as the S&P 500. This would entail buying shares of each company in the index and then adjusting the portfolio each time the index changes and as new money flows into the fund. This can become costly. An alternative is to use the equity index swap. The manager can arrange for an S&P 500 swap, paying for the swap on an agreed upon interest rate. In return, the fund manager receives the return on the S&P 500 index for the stated period of the swap, say five years. The fund manager receives the capital gains and income distributions from the S&P 500 on a monthly basis. Then, he or she pays interest to the counterparty at the agreed upon rate.

Equity swaps have tax advantages as well. Investors can structure a swap to spread out capital gains over a predetermined number of years in return for paying interest at a fixed rate.

Index return swaps offer investors another tool to tailor the timing of investing events and to gain exposure to selected sectors or regions without committing to buying shares in the index. The downside is when the index turns against you, as it can be more difficult to get out of the swap. (To learn more, see An Introduction To Swaps.)

The Bottom Line
As with any investment, equity derivatives carry substantial risk. Prudent investors understand the risk they are assuming and implement strategies to mitigate that risk. As with many investments, those who benefit from the sale of an equity derivative tend to promote them without providing the complete story. Transferring risk is an appropriate investment strategy, but any investor contemplating equity derivatives should understand all the factors when contemplating a trade. (Not sure if these securities are right for you? Check out Are Derivatives Safe For Retail Investors?)

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