Equity derivatives are financial contracts whose value is derived from the value of an underlying stock assets in the secondary market. Equity derivative contracts are complex financial instruments that are used for speculation, hedging and getting access to stocks or markets that would otherwise not be accessible.
These contracts are agreements between buyers and sellers to either buy or sell an underlying equity or related financial instrument at a pre-agreed price. These agreements can either be held until they expire or sold before before the expiry.
Equity derivatives are agreements between a buyer and a seller to either buy or sell the underlying asset in the future at a specific price. They can either hold the right or the obligation to trade the asset at the expiry of the contract.
To trade an equity derivative, the investor needs to be very knowledgeable about the product and the industry, as derivatives allow an investor to speculate and make large gains or losses.
Investing in equity derivatives comes with a number of risks, such as interest rate risk, currency risk, and commodity price risk.
How are Equity Derivatives Traded?
While an OTC derivative is cleared and settled bilaterally between the two counterparties, most equity derivatives are not. Both buyer and seller of the contract agree to trade terms with an exchange, the actual clearing and settlement is done by a clearing house.
Clearing houses will handle the technical clearing and settlement tasks required to execute trades. All derivative exchanges have their own clearing houses and all members of the exchange who complete a transaction on that exchange are required to use the clearing house to settle at the end of the trading session. Clearing houses are also heavily regulated to help maintain financial market stability.
Clearing houses ensure a smooth and efficient way to clear and settle cash and derivative trades. For derivatives, these clearing houses require an initial margin in order to settle through a clearing house. Moreover, in order to hold the derivative position open, clearing houses will require the derivative trader to post maintenance margins to avoid a margin call.
Types of Equity Derivatives
Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (referred to as the strike price) during a specific period of time. American options can be exercised at any time before the expiry of its option period. On the other hand, European options can only be exercised on its expiration date.
In equities, options allow traders to express their bullish or bearish outlook on a stock without necessarily being forced to buy or sell the underlying stock. They may either choose to not exercise their option if they are out-of-the-money and let it expire worthless or sell it before expiry if they are in-the-money.
Stock options are the most commonly traded equity derivatives so they tend to be standardized with many different expiries and strike prices to choose from, improving the liquidity of the contract.
Global stock derivatives are also seen to be a leading indicator of future trends of common stock values.
Stock option types
There are two types of stock options:
A stock call option, which grants the purchaser the right but not the obligation to buy stock. A call option will increase in value when the underlying stock price rises.
A stock put option, which grants the buyer the right to sell stock short. A put option will increase in value when the underlying stock price drops.
Just like options, warrants give the holder the right, but not the obligation, to buy (call warrants) or sell (put warrants) the underlying investment in the future. The company issues the warrants to the holders of its bonds or preferred stock as an incentive to buying the issue.
There are two kinds of warrants:
A call warrant is the right to buy a specified amount of shares from a company at a certain price in the future. A put warrant is the right to sell back a specified number of shares to the issuing company at a specific price in the future.
An equity futures contract is a financial arrangement between two counterparties to buy or sell equity at a specified date, amount, and price. They are regulated on derivative exchanges and used for speculative and hedging purposes. The most common equity futures contract types are index futures and stock futures.
Unlike options, in a futures contract, the buyer has an obligation to buy the asset. In simple terms, the buyer must either sell the futures contract before the expiry date or buy the asset on the date mentioned on the contract at the specified price.
Like a futures contract, a forward contract specifies the future date and price that the buyer should purchase the underlying asset from the seller. The only difference is that a forward contract takes place in the private market and terms are tailored to the parties to the contract.
Convertible bonds allow the holder the option to convert the bonds into shares of the company. Along with the features of the bond (coupon and maturity date), convertible bonds also come with a conversion rate and price associated with it. Because of the conversion feature, such types of bonds pay a lower rate of interest compared to normal bonds.
Swaps are derivatives where returns of two or more different equity stocks are exchanged between two parties. These swaps can be either “plain vanilla” (or just simply “vanilla”) or “exotic”.
Vanilla swaps tend to be simpler, with no special or unique characteristics and are generally based upon the performance of two underlying stocks.
Exotics, on the other hand, tend to have more complex payout structures and may combine several options or may be based upon the performance of more than two underlying assets, sometimes not just stocks.
Why Invest in an Equity Derivative?
The reason for investing in equity derivatives tends to fall into four reasons:
Hedgers: Hedgers use financial equity derivatives to reduce their existing risk or future exposure. An example might be an equity fund manager who wants to protect their downside risk on a particular stock that they own but might not want to sell that stock at the moment. They might choose instead to sell a covered put as a type of insurance in order to limit potential losses that may result from an unexpected price drop of that stock.
Speculators: Speculation is a common, but risky, market activity for financial market participants of a financial market take part in. Speculators take an educated gamble by either buying or selling an asset in the expectation of short-term gains. It is risky because the trade can move against the speculator just as quickly, resulting in potentially significant losses.
Since using derivatives, especially options, is an inexpensive and highly liquid way to gain exposure to an asset without necessarily owning that asset, derivatives are a very important part of the arsenal for financial market speculators. As an example, a speculator can buy an option on the S&P 500 that replicates the performance of the index without having to come up with the cash to buy each and every stock in the entire basket. If that trade works in the speculators favor in the short term, she can quickly and easily close her position to realize a profit by selling that option since S&P 500 options are very frequently traded.
Arbitrageurs: Arbitrage is a very common activity in financial markets that comes into effect by taking advantage of mispricings in assets, resulting in risk-free profits. For example, let’s consider the case where a convertible bond offers the opportunity to convert into common stock of a company at a price that is significantly lower than the traded price of the stock. An arbitrageur may take advantage of that mispricing by buying the convertible bond, converting that into common stock and then selling the stock to lock-in a riskless profit.
Margin traders: In finance terms, margin is the collateral deposited by an investor with their broker or the exchange in order to borrow money to leverage their investment power. By employing leverage, a trader is able magnify gains but also may suffer larger losses.
Equity derivatives are often used by margin traders, especially in when it comes to equity indexes, since it would be incredibly capital-intensive to fund purchases of every single stock that comprises the index basket.