5 most common equity derivatives
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It's a rare professional trader who sticks only to shares and doesn't try the derivatives markets. Obviously, both trading mediums have their distinct advantages. The key differences between equity and derivatives lie in leverage, risk, yield and volatility, and in some situations equity derivatives win their place in a portfolio over equity dealing.
The list of equity-based derivative products runs long – equity options, futures and swaps, warrants, single-stock futures, stock market index futures, convertible bonds, contracts for difference, etc.
Read on to discover some of the common types of derivative markets.
This equity derivative contract allows traders to hedge a portfolio against risks or to take on additional risks and speculate on market movements. Options are commonly based on stocks and stock indices, and represent the right (not the obligation) to buy or sell the underlying asset at a predetermined (strike) pricewithin specified time (expiration date).
Like many types of equity derivatives, options are traded on exchanges that provide transparency and liquidity.
If you use the right to buy or sell the underlying asset, you exercise the option. European options can be exercised only on the expiration day, while American options are more flexible and available to exercise anytime before their expiration.
The value that you gain by exercising the option is called anintrinsic value. In other words, this is the difference between the price of the underlying asset and the strike price. Options with a positive intrinsic value are called in-the-money (ITM);options with a strike price equal to the market price are called at-the-money (ATM); and other options with no intrinsic value (because it can’t be negative) are said to be out-of-the-money (OTM).
Another important term which you’ll come across in connection with options is time value.It depends on multiple factors, including moneyness, time until expiration, and volatility. Overall, as the option approaches its expiration date, its time value decays until it becomes worthless.
Single-stock futures (SSF)
This is another category of equity-based derivatives,which tracks the price of the underlying company’s stock. Like other types of futures, the SSF is an agreement between two parties to exchange the specified number of shares in future, at a price determined today.
Like options and other equity derivatives, SSFs are standardised and are traded on futures exchanges. On OneChicago, for example, trading single-stock futures requires the basic margin requirement of 20%, which is applied to bothbuyers and sellers. In SSF trading, margin is more of a good faith deposit, which is kept by the brokerage until the contract is settled.
The market price of the futures derives from the price of the underlying stock, plus the carrying cost of interest and minus dividends paid over the term of the SSF. The buyer is said to ’go long’, while the seller ‘goes short’. To close the deal, the parties have to take an offsetting position: to sell for long positions, and to buy for short ones.
Single-stock futures are a cost-effective way to buy a stock and, similar to other equity derivatives, can be used as a hedging method to protect open equity positions. However, unlike options, many equity futures are illiquid and are not commonly traded.
Warrants are equity derivatives that grant the right (not the obligation) to buy or sell stock at a certain price on a predetermined date. Similar to options, warrants can be of the following types – call (to buy) or put (to sell), as well as American (can be exercised anytime before expiration) and European (can only be exercised on the expiration date).
Warrants one of the types of equity derivatives that don’t pay dividends or grant voting rights. They are commonly traded over-the-counter, rather than on official exchanges, with a price that includes a premium subject to a time decay: as a warrant is approaching its expiration date (not being in-the-money), the probability for that warrant to be profitable isgradually declining.
Total return equity swap
An equity return swap is an exchange of cash flows between two parties: one takes on an interest payment based on a fixed or floating rate, while the other agrees to pay the return of an underlying asset, called the reference asset. The two parties involved in a swap are referred to as the return payer and the return receiver.
Similar to other equity derivatives types, equity swaps allow the total returnreceiver to gain an exposure to an asset class without actually owning it. This includes both the income that the asset generates and any capital gains. This party benefits from the increase in the asset price over the life of the swap.
In exchange, the return receiver has to pay the set rate to the asset owner over the term of the swap. If the price of the reference asset depreciates over the term of the swap, the return receiver will have to pay the amount by which the asset has decreased to the asset owner.
Contracts for difference
A contract for difference (CFD) is an equity derivative in which the two parties agree to exchange the difference in the current asset’s price at the beginning of the contract and at its termination.
The main objective of a CFD is to enable investors to speculate on the price fluctuations of underlying assets without owning those assets in the first place.
The mechanism behind this type of derivative marketis quite simple. If you think that the price of the underlying asset will increase, you open a CFD position to buy (go long). Similarly, if you predict the asset will drop in price, then you open a CFD position to sell (go short).
If your speculation turns out to be right and the market moves in your favour, you get your profit. However, you lose if asset moves against your position.
CFDs are traded on margin, which entails a substantial level of risk. However, CFD brokers are required to introduce margin calls if the trader’s equity falls below the required margin.
The Capital.com team has created a tutorial on equity derivatives. Check it out here for details on the above-mentioned and other types of derivative markets.