- What is an Equity Derivative?
- Types of Equity Derivatives
- Membership Categories in the Equity Derivatives Market
- Advantages of Equity Derivatives
- Risks Associated with Equity Derivatives
- Difference Between Equity and Equity Derivatives
- Who Should Invest in Equity Derivatives?
- Frequently Asked Questions
A derivative is an instrument that derives its value from its underlying securities, assets or benchmarks. Hence, the fluctuations in the stock market impact the value of equity derivatives. A derivative contract is between 2 or more parties who agree to sell or buy such derivatives on the stock market or over the counter (OTC).
What is an Equity Derivative?
Equity derivatives derive their value from one or more underlying equity securities. The types are futures, options, warrants, and swaps. The most popular instruments by far are options and futures. Investors can trade in futures and options of stocks and indices.
They use equity derivatives as an alternative to hedge risk. For instance, if an investor invests in stocks then they can use equity derivatives. Since these instruments derive their value from the underlying stocks, hedging is possible. The investor can protect them against potential loss by entering into a put option.
Investors use derivatives as a mechanism to speculate in the market and generate profits. For instance, an investor can purchase options rather than buy actual stocks of the company. This way the investor can aim for a higher return potential. First of all, buying stocks is costlier than purchasing options. Secondly, the investor can hedge against potential market risks by entering into a call or put options against the price of such stocks.
Types of Equity Derivatives
A legally binding contract to buy or sell the underlying security at a later time. Future contracts are organized or standardized agreements that specify the quantity, quality (in the case of commodities), delivery date, and location for a future date of payment. The contract’s expiry date is a predetermined time period. Futures can be settled by the delivery of the underlying asset or by cash when they expire. The ability to settle commitments resulting from future or option contracts in cash is known as cash settlement.
This type of derivatives contract allows the buyer or contract holder the right, but not the duty, to purchase or sell the underlying asset. This purchase or sell will be at a predefined price within or at the end of a specific period. The right is purchased by the buyer/holder of the option from the seller/writer for an amount known as the premium. When the buyer or holder of an option exercises his right, the seller or writer is required to settle the option as per the terms of the contract.
Swaps are private agreements between two parties. These parties agree to exchange cash flows on a future date at a predefined rate. These are a portfolio of forward contracts for these parties. The most common swaps in the derivative market are interest rate swaps and currency swaps.
Most of the options traded on options exchanges have a maximum maturity of nine months. These options typically have durations of up to one year. Warrants are longer-dated options that are typically traded over the counter.
Membership Categories in the Equity Derivatives Market
The following are the types of membership categories in the equity derivatives market:
- Trading Members– These members can trade in the derivatives market for themselves or on behalf of their clients.
- Clearing Members– They can settle derivatives contracts for themselves or on behalf of trading members.
- Self Clearing Members– Such members can settle only their own contracts in the equity derivative market.
Advantages of Equity Derivatives
- Hedge Against Market Fluctuations: To lower the risk of an asset’s price falling, hedging entails buying comparable securities. This serves as a safety net against rising equity prices that an investor purchases. It also has the potential to protect investors from a decrease in price.
- Arbitrage: Arbitrage refers to the simultaneous sale and purchase of an asset to take advantage of price differences in two different stock markets. An investor can gain from the stock price difference in the stock market and equity derivative market for the same stock.
- Cost: The cost of investing in this market is lower than the investment in a stock market. This makes it more cost effective. Moreover, an investor pays margin money which is much lower than the actual transaction value. This way the investor can avail an exposure to high value transactions, gain from their potential estimations, and grow their money.
- Leverage: By investing in small amounts an investor can have greater exposure to the equities in comparison to the exposure in the stock market.
Risks Associated with Equity Derivatives
- Market Risk: The overall risk associated with any investment is market risk. Instead of one or more securities falling out of favour, the risk is that the market as a whole could lose value. Economic recessions, general economic conditions, changes in interest rates, and other factors can all increase market risk. It is crucial to do extensive study and assess the potential that an investment will be profitable before you begin trading in it.
- Counterparty Risk: An equity derivative contract’s counterparty or other parties could become financially incapable of their commitments. Counterparty risk goes by a variety of names, including credit risk, litigation risk, settlement risk, etc., but it is the same risk under each name. When two parties sign a contract, it’s possible that one of them won’t keep their end of the bargain.
- Volatility: Volatility risk arises when the value of the contract’s underlying security fluctuates regularly. With an equity derivative, volatility risk is high due to fluctuations in the stock market. Due to price changes, volatility can have an impact to the point where one party loses all of the value overnight.
Difference Between Equity and Equity Derivatives
The following are the differences between equity and equity derivatives:
- Equity is an investment product that derives its value from factors such as demand, supply, politics, potential growth, competition, and so on. On the other hand, equity derivatives derive their value from the underlying securities. Hence, one of the factors in the valuation of equity derivatives is the equity price.
- Stocks are independent investment options, whereas equity derivatives are limited to an expiry date.
- An investment in an equity stock can be held for a short term or a long term. The investment objective of investing in equity stocks differs. However, equity derivatives can be held only till the date of expiry.
Who Should Invest in Equity Derivatives?
Investors who understand the derivatives market, the risk associated with equities, market volatility, hedge process, and arbitrage opportunities can consider equity derivatives. It provides portfolio diversification and hedge against the risk of price fluctuations. However, an investor must understand the technical details and associated processes related to the market.
Frequently Asked Questions
An investor can trade in equity derivatives by opening a trading account with any broker. If you already have a trading account then place your derivative contract online by logging into your account.
Yes, equity derivatives are traded over the counter.
The clearing and settlement of all trades on equity derivatives are done through a clearing house. The clearing house is an independent entity in governance and membership from the Derivative Exchange/Segment. A trader can settle derivative contracts by either closing or squaring off their position before the expiry date. Otherwise, they have to mandatorily opt for a physical settlement and take delivery. Physical settlement is applicable to all stocks under futures and options contracts.
Yes, physical settlement is applicable to equity derivatives. Each derivative has an expiry date. The trader has to close or square off the position before the expiry date. If the trader fails to do so then the trader will have to take a delivery for the lot size agreed in the contract. However, in the case of options contracts, only in-the-money options are subject to physical settlement.
Stocks and indexes are traded in the equity derivative market.