What is Equity Derivative- Meaning, Benefits and Types

Equity derivatives is one of the most common terms in the finance market. Many people fail to differentiate between equity and equity derivatives, which are very distinct terms. One of the most significant differences between these two is ownership. 

While equity gives you a right to that asset, you cannot own equity derivatives. Therefore, this article will discuss what equity derivatives are in the stock market, their types, and how they can benefit an investor. So, read on till the end!

What are Equity Derivatives in the Stock Market?

An equity derivative is a financial contract that derives its value from the price of an attached equity security, such as a stock. These are usually time-bound contracts, and the time period may vary depending on the type of derivative an investor chooses to invest in. 

These derivatives help investors by providing a way to make money depending on the position of the stock without owning the asset itself. As of June 2023, the Equity derivative notional outstanding rose by 14.2% to $573.7 trillion.

Types of Equity Derivatives

There are many types of derivatives in the stock market. Some of the most common types are:

Future Contracts 

Equity futures are standardised, legally-binding contracts between two counterparties. These contracts require the buyer to buy and the seller to sell assets at a set price on a future date agreed upon by both parties. There are mainly three types of futures:

• Commodity Futures: These are based on physical products like agricultural produce, energy, or metals.

• Financial Futures: These use instruments like stocks, bonds, currencies, etc., as assets.

• Index Futures: These contracts are based on an underlying asset i.e., a stock index such as the S&P 500.

Options

These contracts allow the buyer the right to buy or sell any underlying asset at a fixed rate (strike price) that must be traded within a set period. In options, traders can articulate their bullish or bearish outlook on a particular stock without the need to buy or sell the underlying stock. 

There are mainly two types of options:

• Call Options: This type of options give the buyer the right to buy assets. They benefit when the stock prices rise above the strike prices and face losses when the premium paid on the option is limited.

• Put Options give the buyer the right to sell, and they profit if the stock prices fall below the fixed rate. Like call options, put options also limit the loss to the premium paid on the option.

Swaps 

These are financial agreements between two parties to exchange cash flows. This kind of equity asset often functions on two legs. One is based on the performance of an equity index or individual stock, while the other one is based on fixed or floating interest rates. The most common types of swaps are:

• Interest Rate Swaps: These swaps are based on the exchange of interest payments where the parties exchange fixed and floating rate interest payments on a principal amount.

• Commodity Swaps: Here, the exchange of principal amount and interest takes place in different currencies. This is mainly used to hedge forex risk and manage currency exposure.

• Credit Default Swaps (CDS): These are mainly used to protect against credit risk. In CDS, the seller agrees to pay the buyer if a specified entity defaults on its debt. 

Forwards

Forwards legally obligate the purchase and sale of a specified quantity of underlying assets at a fixed price at a future date. The primary dissimilarity between futures and forwards is that forwards can be customised to meet specific needs, while futures are standardised. 

Why Invest in an Equity Derivative?

Equity derivatives are a worthy option to invest in as they:

•  Give investors significant leverage to hold a larger position with a smaller capital outlay.

• Protect the existing investments from market risks.

• Help market experts speculate on the price movements of underlying assets.

• Diversify portfolios by helping gain exposure to different markets or asset classes.

• Offer some tax advantages over traditional investments in some cases.

• Provide arbitrage opportunities by controlling price discrepancies between the derivative and the underlying asset.

Benefits of Equity Derivatives

Equity derivatives in the stock market can prove to be very beneficial. Some aspects that are especially beneficial are:

Risk Management

Equity derivatives help protect against price declines and lock in profits. This type of trading also helps predict the price and gain from that volatility by offsetting the losses. It can also reduce concentration risk by spreading it across different asset classes.

Leverage

Leveraging helps investors control a large portion of an underlying asset with a small initial investment. Leveraging enhances returns, creates exposure, increases trading opportunities, and provides access to specialised products.

Hedging Options

Equity derivatives offer a strategic and flexible way of minimising risks and mitigating potential losses. They also tailor protection to risks by using different strategies, proving cost-efficient, and maintaining exposure.

Higher Return

The leveraged nature of equity derivatives helps in amplifying gains. By hedging strategies and reducing downside risk, investors can gain more profit when the market turns favourable. Options and volatility trading can also increase the returns on investment.

Vast Variety

Equity derivatives in the stock market give investors a wide range of assets that align with their interests. The various types of contracts mentioned above give investors options that suit them, and strike prices offer a security that allows them to diversify.

Who Should Invest in Equity Derivatives?

Equity derivatives are complex financial mediums that can be used for a variety of monetary benefits. But these come with certain risks and complexities. Therefore, this type of trading is generally suitable for investors who:

• Have a high-risk tolerance

• Have a good understanding of the stock market

• Can actively manage their positions

• Have a well-defined plan as to how and what they invest in

Generally, equity derivatives are suitable for hedge fund managers, institutional investors, and experienced individual investors with stable investment experience.

Conclusion

Equity derivatives in the stock market offer a process to hedge trading options and investments in a way that minimises risks and is balanced in its approach. This trading option also helps diversify investments and see significant returns. 

However, just like every other investment avenue, equity derivatives come with their fair share of risks. Thus, it is essential to consult a financial advisor before investing to see if they align with your financial circumstances and goals. You could also use an LTP calculator to make things easier by allowing you to make wise buying and selling decisions.