What is an Equity Derivative

An equity derivative is a financial instrument whose value is based on equity movements of the underlying asset. For example, a stock option is an equity derivative, because its value is based on the price movements of the underlying stock. Investors can use equity derivatives to hedge the risk associated with taking long or short positions in stocks, or they can use them to speculate on the price movements of the underlying asset. 

Key Takeaways

  • Equity derivatives are financial instruments whose value is derived from price movements of the underlying asset.
  • Traders use equity derivatives to speculate and manage risk.
  • Equity derivatives can take on two forms: equity options and equity index futures.
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Basics of Equity Derivative

Equity derivatives can act like an insurance policy. The investor receives a potential payout by paying the cost of the derivative contract, which is referred to as a premium in the options market. An investor that purchases a stock, can protect against a loss in share value by purchasing a put option. On the other hand, an investor that has shorted shares can hedge against an upward move in the share price by purchasing a call option.

Equity derivatives can also be used for speculation purposes. For example, a trader can buy equity options, instead of actual stock, to generate profits from the underlying asset's price movements. There are two benefits to such a strategy. First, traders can cut down on costs by purchasing options (which are cheaper) rather than the actual stock. Second, traders can also hedge risks by placing put and call options on the stock's price.

Other equity derivatives include stock index futures, equity index swaps, and convertible bonds.

Using Equity Options

Equity options are derived from a single equity security. Investors and traders can use equity options to take a long or short position in a stock without actually buying or shorting the stock. This is advantageous because taking a position with options allows the investor/trader more leverage in that the amount of capital needed is much less than a similar outright long or short position on margin. Investors/traders can, therefore, profit more from a price movement in the underlying stock. 

For example, buying 100 shares of a $10 stock costs $1,000. Buying a call option with a $10 strike price may only cost $0.50, or $50 since one option controls 100 shares ($0.50 x 100 shares). If the shares move up to $11 the option is worth at least $1, and the options trader doubles their money. The stock trader makes $100 (position is now worth $1,100), which is a 10% gain on the $1,000 they paid. Comparatively, the options trader makes a better percentage return.

If the underlying stock moves in the wrong direction and the options are out of the money at the time of their expiration, they become worthless and the trader loses the premium they paid for the option.

Another popular equity options technique is trading option spreads. Traders take combinations of long and short option positions, with different strike prices and expiration dates, for the purpose of extracting profit from the option premiums with minimal risk.

Equity Index Futures

A futures contract is similar to an option in that its value is derived from an underlying security, or in the case of an index futures contract, a group of securities that make up an index. For example, the S&P 500, the Dow index, and the NASDAQ index all have futures contracts available that are priced based on the value of the indexes. However, the values of the indexes are derived from the aggregate values all the underlying stocks in the index. Therefore, index futures ultimately derive their value from equities, hence their name "equity index futures". These futures contracts are liquid and versatile financial tools. They can be used for everything from intraday trading to hedging risk for large diversified portfolios.

While futures and options are both derivatives, they function in different ways. Options give the buyer the right, but not the obligation, to buy or sell the underlying at the strike price. Futures are an obligation for both the buyer and seller. Therefore, the risk is not capped in futures like it is when buying an option.