What is an 'Equity Derivative'

An equity derivative is a derivative instrument with underlying assets based on equity securities. An equity derivative's value will fluctuate with changes in its underlying asset's equity, which is usually measured by share price. Investors can use equity derivatives to hedge the risk associated with taking a position in stock by setting limits to the losses incurred by either a short or long position in a company's shares.

BREAKING DOWN 'Equity Derivative'

The investor receives this insurance by paying the cost of the derivative contract, which is referred to as a premium. 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. Options are the most common equity derivatives because they directly grant the holder the right to buy or sell equity at a predetermined value. More complex equity derivatives include equity index swaps, convertible bonds or stock index futures.

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. There is however, a risk associated with using options to assume a position in a stock. If the underlying stock trades in the wrong direction and the options are out of the money at the time of their expiration, they become absolutely worthless and all the capital used to assume the position is lost.

Another popular equity options technique is trading option spreads. Traders take combinations of long and short positions of different options for the same underlying stock, 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 the name equity index futures. These futures contracts are very liquid and are very versatile and useful financial tools. They can be used for everything from intraday trading to hedging risk for large diversified portfolios.

RELATED TERMS
  1. Underlying Asset

    A term used in derivatives trading, such as with options. A derivative ...
  2. Derivative

    A derivative is a security with a price that is dependent upon ...
  3. Underlying

    1. In derivatives, the security that must be delivered when a ...
  4. Options On Futures

    An option on futures gives the holder the right but not obligation ...
  5. Economic Derivative

    Economic derivatives are contracts that allow hedgers and speculators ...
  6. Derivatives Time Bomb

    A possibile situation where the financial markets plunge into ...
Related Articles
  1. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  2. Trading

    Examples Of Exchange-Traded Derivatives

    We look at some of the most common exchange-traded derivatives.
  3. Trading

    Are Derivatives Safe For Retail Investors?

    These vehicles have gotten a bad rap in the press. Find out whether they deserve it.
  4. Investing

    Complex Derivatives Made Simple

    Many ETFs hold derivatives. Here's how to be sure if you own a derivatives-based ETF.
  5. Trading

    Futures, Derivatives and Liquidity: More or Less Risky?

    Futures and derivatives get a bad rap after the 2008 financial crisis, but these instruments are meant to mitigate market risk.
  6. Trading

    Options Basics Tutorial

    Discover the world of options, from primary concepts to how options work and why you might use them.
  7. Financial Advisor

    SEC Derivatives Rule May Limit Diversification

    The SEC has proposed rules that will limit the use of derivatives by fund managers. Critics believe the rules will impede funds' ability to diversify.
  8. Trading

    How to Make Money by Trading Index Options

    Index options are less volatile and more liquid than regular options. Understand how to trade index options with this simple introduction.
  9. Trading

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  10. Trading

    Are Derivatives A Disaster Waiting To Happen?

    They've contributed to some major market scandals, but these instruments aren't all bad.
RELATED FAQS
  1. What is the difference between derivatives and options?

    Learn how options are one type of derivative and how equity options derive their value from a stock, and understand other ... Read Answer >>
  2. What kinds of derivatives are traded on an exchange?

    Learn about the different types of derivatives traded on exchanges, including options and futures contracts, and discover ... Read Answer >>
  3. Can mutual funds invest in derivatives?

    Find out about mutual fund investment options, and understand whether mutual funds are permitted to include investments in ... Read Answer >>
  4. What does it mean to take delivery of a derivative contract?

    Find out more about derivative contracts and what it means when the holders of derivative contracts take delivery of the ... Read Answer >>
  5. How is the price of a derivative determined?

    Learn how different types of derivatives are priced, including how futures contracts are valued and the Black-Scholes option ... Read Answer >>
Hot Definitions
  1. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  2. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  3. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  4. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  5. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  6. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
Trading Center