What is equity derivatives in stock market?

The concept of equity derivatives may be challenging for people to understand, and in fact, many people know very less about them. However, we should note that derivatives are a very lucrative investment option. Those aware of them take good advantage of them to diversify their holdings and make the most out of their investments. Yet there is a section that still remains uninformed, and hence you may be wondering now what the equity derivatives definition is? What is an equity derivative in the stock market? This article will cover different crucial aspects of equity derivative investment in India. We will discuss the benefits of derivative investments also in great detail.

What is Equity Derivatives?

Equity derivatives definition: Before you understand equity derivatives’ meaning, let us know what a derivative is at first. The derivatives are financial assets whose value depends upon underlying assets. . This asset can be a bond, commodity, exchange-traded funds (ETFs), etc. Likewise, equity is also one of them. In an equity derivative, two parties (the buyer and seller) will enter an agreement to buy or sell an asset at a specific price in the future. The price value of these financial assets is hugely dependent on the performance of the underlying instruments. If the assets in which a particular derivative deals, the derivative will also rise in value. Conversely, if these assets trend poorly in then, the derivatives also give poor returns. 

The investors must take note of a very crucial point here. On buying the equity derivatives, the investors take their share in the performance of the asset that the derivative deals in. The investors do not get any kind of ownership of the equities of that company. As you do not own a company’s equity, you are not directly liable for the risks it faces. Therefore, the risk very much lowers. So investing in derivatives reduces the risk of losses to a good extent. 

Though equity investments are indeed a good option, this task of investing in derivatives is a little challenging. This demands a lot of research about the kind of companies a particular derivative invests in. One would have to assess the financial position properly and predict the performance of the company as accurately as possible. So, it is wise to take the suggestions and inputs of recognized financial experts who can guide you. They can provide the right advice that would help you avoid undue risks and make profits at the same time.

Benefits of Equity Derivatives

Investing in derivatives has a number of advantages for investors. This is the reason many financial experts advise investors to have a fair share of holdings in derivatives. At least some portion of the investment portfolio should contain the derivatives. Some of the major advantages to list include the following. Let us have a proper glance at each one of them. 

Risk Management

An equity derivative is an excellent investment option for investors who want to transfer or transform the risks with assets. There is the movement of the risks involved from the risk-averse individuals to the ones who are heavy-risk takers. This thus proves to be a very good deal for small investors and those who just began their financial journey.

Physical Settlement

An equity derivative is a great investment option for retaining shares in the long term and availing the price fluctuations in the short time. Investors who prefer to hold their investments for long periods of time will like derivative investments. It is possible through a physical settlement process. This scenario leads to a situation where an investor can make money on your shares that are lying idle.

Protection Against Fluctuation

You can invest in related securities and minimize the risks very well.  For instance, it is possible to reduce the impact of an adverse change in an asset’s price. With this, you can have protection from price declination for the shares you own already. Along with this, you benefit from the price inclination for the shares you are willing to purchase. 

Arbitrage Trading

Arbitrage trading is the process of selling an asset in one market while buying in another at the same time to benefit from the price difference. There is a benefit because a particular share often tends to be more valuable in one market than the other. The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) are these two markets. The price of a stock trading on the Bombay Stock Exchange may differ from the price at which it may be trading on the National Stock Exchange.

Margin Trading

Trading on a contract requires the investors to pay a margin rather than the entire amount in one single instance. With Margin Trading, it is possible to maintain a high outstanding. At the same time, the investors can also take the profit from accurate predictions to exponentially high growth. So, if you are successful in gazing in the right trend direction, you can make a huge amount of profit from the investments made in derivatives. 

Understanding Equity Derivatives

There are two primary forms in which equity derivatives carry out. The first one is the Equity Options, whereas the second one includes the Equity Index Futures.

Equity Options

In an equity call option, the option buyer will only have the right to buy an underlying asset at a specific price on or before a pre-decided date. In an equity put option sell, the option buyer will only have the right to sell. In comparison, the option seller will only have an obligation to sell an underlying asset regarding a call while buying as regards to put. There will be 100 shares of the underlying stock in an equity option contract. The strike prices of equity options are represented as .5, 1, 2.5, 5, or 10 points based on their price level. 

The equity options contain only one underlying equity asset. Investors and traders can use the equity options to opt for both the long and the short positions for a stock. They need not require to buy the stock or even short it. This is beneficial for the investors as they get more leverage without even taking the position for the option. This is because the capital requirement is far less than what it would be in the case of straightforward positions on margin. In this way, the investors and traders make a good chunk of money from the changes in prices of the underlying stocks.

Equity Index Futures  

The futures contract resembles the equity option in the way that both of them deal with only one underlying stock. The Equity Index futures, on the contrary, refer to futures contracts that take place on equity indices. There is more than one security here as the index consists of multiple stocks trading in the share market. Most cash-settled contracts come with the quarterly expiration dates scheduled for March, June, September, and December. In an Equity Index Future, investors will get exposure to price fluctuations on an underlying Index. So, you can avail the price fluctuations of a group of equities where you do not need to trade in the individual constituents. You can buy or sell an underlying asset at a fixed price on a future date.

What are the Types of Equity Derivatives?

Now that you understand the meaning of equity derivatives let’s try to understand the different types of equity derivatives in India.

Options

An option contract will give you the right to buy or sell an underlying asset (stock, bond, commodity, etc.) at a pre-decided price point in the future. The good part about the options contract is that you will not have any obligation to make the trade necessarily. The options price is known by the term ‘Premium’. It depends on a few factors such as expiry date, strike price, and the fluctuation in the price of a stock.  There are two types of options:

• Put option: In this contract, the option buyer will get the right, not the obligation, to sell or sell short an underlying asset at a predetermined future date at a predetermined price. 
• Call option: In this contract, the option buyer will get the right, not the obligation, to buy an underlying asset within a specific period at a predetermined price.

Futures

A futures contract is an agreement between two parties where the buyer is obligated to buy and receive an underlying asset. The seller is obligated to sell and deliver it at a predetermined price at a predetermined date in the future. The seller is also required to sell the asset on the pre-decided. Therefore, we can say that the buyer also carries the responsibility to buy the asset on the date agreed upon while making the contract.  

Warrants

In a warrant, the holder will get the right to buy/sell an underlying asset at a certain price at a specific future date instead of an obligation. Companies offer warrants as incentives to the preferred stock and bondholders.

Two types of warrants are there. One is the Call warrant, and the other is the Put warrant. 

Call warrants —  in this, you will get the right to purchase a security in a call warrant. 
Put warrants — here; you will get the right to sell a security in a put warrant. 

Forwards

Like the futures contract, the forwards carry a particular date in the future and the price at which the transaction will occur. The buyer has to purchase the underlying security with these pre-determined conditions. The buyer needs to buy the asset as per the conditions necessarily. He cannot defy the terms of the agreement.

Convertible bonds

Convertible bonds enable the investors to convert the bonds they have into the company’s shares. Apart from the characteristics of regular bonds such as a coupon, maturity date, etc., the convertible bonds have conversion rates and associated priceIn addition; since conversion is possible in these bonds, the rates of interest they come with are lower than the regular bonds. 

Swaps

A swap is a contract between two parties, where one party will exchange the value of an asset with another at a predetermined price at a predetermined time in the future. This exchange can be on floating and fixed interest rates,  equity returns, currencies of different countries, and many more.

Risks Associated With Derivative investments

To understand equity derivatives in the stock market in detail, you must understand the risks associated with derivatives. Before entering into derivatives trading, you must understand different associated risks to manage effectively. The first thing you need to understand is that the market fluctuates constantly. So, a vigilant trader can stick to and make profits in this market.

Market Risk

There is a market risk to every investment, and so with derivatives. This risk indicates the overall market loss in value. It happens due to different factors such as economic recessions, economic conditions, shifts in interest rates, and political unrest. And Therefore, before investing in a derivative contract, you must thoroughly conduct research and determine profitability. 

Counterparty Risk

Counterparty risk means when one of the two parties doesn’t follow commitment in a contract. There are different names for counterparty risks: credit risk, legal risk, settlement risk, etc.

Duration Limit

Every derivative comes with an expiration date. When the date comes to due, contract expiration comes along with it. It will lead to loss when the investment fails in that predetermined time. 

Volatility

The constant change in the value of an underlying asset of a contract is called volatility. There is a chance that price fluctuations can make one party lose the entire value overnight.