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.

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