Types Of Equity Derivatives

Several varieties of equity derivatives are employed in equity trading, including:

1. Options:

Options represent financial derivative contracts conferring the buyer the right, though not the obligation, to buy or sell an underlying asset at a predetermined price (referred to as the strike price) within a specific timeframe.

In the realm of equities, options enable traders to express bullish or bearish sentiments about a stock without being obligated to buy or sell the actual shares. Traders may choose not to exercise out-of-the-money options, letting them expire worthless, or sell in-the-money options before expiry.

 

Stock options, the most commonly traded equity derivatives, are often standardized with various expiries and strike prices, enhancing contract liquidity. Global stock derivatives are considered leading indicators of future trends in common stock values.

There are two main types of stock options:

• Stock call option: Grants the buyer the right (but not the obligation) to purchase stock. The value of a call option increases as the underlying stock price rises.

• Stock put option: It bestows upon the purchaser the privilege to engage in a short sale of the underlying stock. The value of a put option increases as the underlying stock price drops.

2. Futures:

An equity futures contract is a financial agreement between two parties to buy or sell a certain amount of equity at a predetermined date and price. These contracts are overseen by derivative exchanges and serve both speculative and hedging purposes. The primary categories of equity futures contracts include index futures and stock futures.

 

In contrast to options, a futures contract imposes an obligation on the buyer to purchase the asset. To put it plainly, the buyer must either sell the futures contract before its expiration date or acquire the asset on the specified date mentioned in the contract at the agreed-upon price.

3. Warrants:

Similar to options, warrants provide the holder with the right, but not the obligation, to either buy (call warrants) or sell (put warrants) the underlying investment at a later date. Companies issue warrants to bond or preferred stockholders as an incentive to invest in their offerings.

There are two types of warrants:

• Call Warrant: This grants the holder the right to purchase a predetermined quantity of shares from a company at a specified price in the future.

• Put Warrant: This provides the holder with the right to sell a specified number of shares back to the issuing company at a predetermined price in the future.

4. Equity Swaps:

This represents a pact between two entities to swap cash flows, where one is linked to the returns of an equity index and the other is tied to the index or stock itself. Equity swaps are commonly employed to circumvent transaction costs associated with buying or selling stocks, offering investors a cash flow mirroring the returns of a particular stock.

Differences Between Equity and Index Derivatives

Key Takeaways

• Options provide traders with the right to buy or sell assets without obligation.

• Equity futures contracts involve predetermined agreements for buying or selling equity.

• Warrants, similar to options, grant the right to buy or sell investments.

• Equity swaps exchange cash flows tied to equity returns to avoid transaction costs.

Frequently Asked Questions

1. How do investors buy equity derivatives, and who facilitates the transactions?

Investors purchase equity derivatives directly from the stock market, while sellers sell to the stock market, which, in turn, facilitates the transaction between the buyer and seller.

 

2. What are the various types of equity derivatives available in the market?

Equity derivatives come in different forms, including equity options and equity index futures. Additionally, equity swaps, warrants, and single-stock futures are categorized as equity derivatives.

 

3. What distinguishes equity from derivatives?

The primary difference lies in the driver of value or price. Equity derives its value from market conditions, demand and supply, and company/economy-related events. Conversely, derivatives derive their value from underlying assets like indexes, stocks, currencies, etc.

 

4. Why engage in equity derivatives trading?

Equity derivatives enable investors to gain exposure to the performance of the underlying investment without owning a portion of the company's stock. Moreover, the risks associated with equity options are generally lower than those linked to owning the stock outright.

 

5. Can you provide an example of equity derivatives?

An equity derivative is a financial tool whose worth is determined by the fluctuations in the value of the underlying asset. For instance, a stock option qualifies as an equity derivative because its value is contingent on the price fluctuations of the underlying stock.