Equity Derivatives Explained

What are Equity Derivatives?

Equity derivatives are financial instruments whose value is derived from the performance of one or more underlying equity securities, such as individual stocks or stock market indexes. They do not represent direct ownership but rather a contract based on the price movements of the underlying equity.

Key Concepts

Types of Equity Derivatives

• Options: Contracts giving the buyer the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specified price on or before a certain date.
• Futures: Agreements to buy or sell an underlying asset at a predetermined price at a specified time in the future.
• Swaps: Agreements between two parties to exchange cash flows based on underlying equity performance.

Underlying Assets

The underlying assets can range from individual common stocks to broad market indexes like the S&P 500 or FTSE 100, providing diverse investment and hedging possibilities.

Deep Dive into Options and Futures

Options Mechanics

Call options profit from rising prices, while put options profit from falling prices. The strike price and expiration date are crucial terms. Premiums are paid for the right to exercise.

Futures Mechanics

Equity index futures are commonly traded. They are standardized contracts traded on exchanges and require margin accounts. They are often used for portfolio hedging.

Applications of Equity Derivatives

Equity derivatives serve multiple purposes:

• Hedging: Protecting portfolios against adverse price movements.
• Speculation: Betting on future price directions with leveraged capital.
• Arbitrage: Exploiting price discrepancies between the derivative and its underlying asset.
• Portfolio Management: Adjusting market exposure efficiently.

Challenges and Misconceptions

A common misconception is that derivatives are inherently risky. While they can amplify gains and losses, their risk management capabilities are significant when used appropriately. Understanding the contract terms is vital.

FAQs

Are equity derivatives only for institutional investors?

While historically more accessible to institutional investors, many equity derivatives, particularly exchange-traded options and futures, are now accessible to sophisticated individual investors.

What is the primary difference between an option and a future?

An option grants a right, not an obligation, while a future contract creates an obligation for both parties to fulfill the agreement at expiration.