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.