What Are Equity Derivatives?
Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Equity derivatives are trading instruments based on the price movements of underlying asset equity. These financial instruments include equity options, stock index futures, equity index swaps, and convertible bonds.
With an equity derivative, the investor doesn’t buy a stock, but rather the right to buy or sell a stock or basket of stocks. To buy those rights in the form of a derivative contract, the investor pays a fee, more commonly known as a premium.
How are Equity Derivatives Used?
The value of an equity derivative goes up or down depending on the price changes of the underlying asset. For this reason, investors sometimes buy equity derivatives — especially shorts, or put options — to manage the risks of their stock holdings.
Investors buy the rights (or options) to buy or sell an asset via a derivative contract, as mentioned.
💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.
4 Types of Equity Derivatives
Generally, there are four types of equity derivatives that investors should familiarize themselves with: Equity options, equity futures, equity swaps, and equity basket derivatives.
1. Equity Options
Equity options are one form of equity derivatives. They allow purchasers to buy or sell a given stock within a predetermined time period at an agreed-upon price.
Because some equity derivatives offer the right to sell a stock at a given price, many investors will use a derivatives contract like an insurance policy. By purchasing a put option on a stock or a basket of stocks, can purchase some protection against losses in their investments.
Recommended: How to Trade Options: A Beginner’s Guide
Not all put options are used as simple insurance against losses. Buying a put option on a stock is also called “shorting” the stock. And it’s used by some investors as a way to bet that a stock’s price will fall. Because a put option allows an investor to sell a stock at a predetermined price, known as a strike price, investors can benefit if the actual trading price of the stock falls below that level.
Call options, on the other hand, allow investors to buy a stock at a given price within an agreed-upon time period. As such, they’re often used by speculative investors as a way to take advantage of upward price movements in a stock, without actually purchasing the stock. But call options only have value if the price of the underlying stock is above the strike price of the contract when the option expires.
For options investors, the important thing to watch is the relationship between a stock’s price and the strike price of a given option, an options term sometimes called the “moneyness.” The varieties of moneyness are:
• At-the-money (ATM). This is when the option’s strike price and the asset’s market price are the same.
• Out-of-the-money (OTM). For a put option, OTM is when the strike price is lower than the asset’s market price. For a call option, OTM is when the strike price is higher than the asset’s market price.
• In-the-money (ITM). For a put option, in-the-money is when the market price of the asset is lower than the option’s strike price. For a call option, ITM is when the market price of the asset is higher than the option’s strike price.
The goal of both put and call options is for the options to be ITM. When an option is ITM, the investor can exercise the option to make a profit. Also, when the option is ITM, the investor has the ability to resell the option without exercising it. But the premiums for buying an equity option can be high, and can eat away at an investor’s returns over time.
Recommended: How to Sell Options for Premium
2. Equity Futures
While an options contract grants the investor the ability, without the obligation, to purchase or sell a stock during an agreed-upon period for a predetermined price, an equity futures contract requires the contract holder to buy the shares.
A futures contract specifies the price and date at which the contract holder must buy the shares. For that reason, equity futures come with a different risk profile than equity options. While equity options are risky, equity futures are generally even riskier for the investor.
One reason is that, as the price of the stock underlying the futures contract moves up or down, the investor may be required to deposit more capital into their trading accounts to cover the possible liability they will face upon the contract’s expiration. That possible loss must be placed into the account at the end of each trading day, which may create a liquidity squeeze for futures investors.
Equity Index Futures and Equity Basket Derivatives
As a form of equity futures contract, an equity index futures contract is a derivative of the group of stocks that comprise a given index, such as the S&P 500, the Dow Jones Industrial Index, and the NASDAQ index. Investors can buy futures contracts on these indices and many others.
Being widely traded, equity index futures contracts come with a wide range of contract durations — from days to months. The futures contracts that track the most popular indices tend to be highly liquid, and investors will buy and sell them throughout the trading session.
Equity index futures contracts serve investors as a way to bet on the upward or downward motion of a large swath of the overall stock market over a fixed period of time. And investors may also use these contracts as a way to hedge the risk of losses in the portfolio of stocks that they own.
3. Equity Swaps
An equity swap is another form of equity derivative in which two traders will exchange the returns on two separate stocks, or equity indexes, over a period of time.
It’s a sophisticated way to manage risk while investing in equities, but this strategy may not be available for most investors. Swaps exist almost exclusively in the over-the-counter (OTC) markets and are traded almost exclusively between established institutional investors, who can customize the swaps based on the terms offered by the counterparty of the swap.
In addition to risk management and diversification, investors use equity swaps for diversification and tax benefits, as they allow the investor to avoid some of the risk of loss within their stock holdings without selling their positions. That’s because the counterparty of the swap will face the risk of those losses for the duration of the swap. Investors can enter into swaps for individual stocks, stock indices, or sometimes even for customized baskets of stocks.
4. Equity Basket Derivatives
Equity basket derivatives can help investors either speculate on the price movements or hedge against risks of a group of stocks. These baskets may contain futures, options, or swaps relating to a set of equities that aren’t necessarily in a known index. Unlike equity index futures, these highly customized baskets are traded exclusively in the OTC markets.
💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).
The Takeaway
Equity derivatives are trading instruments based on the price movements of underlying asset equity. Options, futures, and swaps are just a few ways that investors can gain access to the markets, or hedge the risks that they’re already taking.
Investors interested in utilizing equity derivatives as a part of their larger investing strategy should probably do a lot of homework, as options and futures require a good amount of background knowledge to use effectively. It may also be worth speaking with a financial professional for guidance.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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