Equity vs Derivatives: Meaning, Differences, How to Choose

Equity and derivatives are two major categories of financial instruments, but they differ in ownership, value, risk, trading mechanisms, and purpose. Equity represents ownership in a company, while derivatives are contracts whose value derives from an underlying asset such as a stock, index, currency, or commodity.

From how they function to the risks involved, this article discusses the key differences between equity and derivatives.

Key Takeaways

• Equity gives you part-ownership in a company, while derivatives derive their value from an underlying asset.
• Equity returns may come from share price gains and dividends, while derivative profits or losses depend on contract price movements.
• Derivatives are commonly used for hedging, speculation, and arbitrage, whereas equity allows direct participation in a company's growth.
• Shares do not have an expiry, but derivative contracts end on a specified expiry date.
• Equity and derivatives involve different capital requirements, risk levels, and settlement mechanisms.

What is Equity?

Equity is a financial instrument that provides ownership in a company when purchased. It is commonly referred to as stocks, shares, or equity shares among stock market participants.

Equity shares provide you with part-ownership in a company based on the proportion of the shares you hold. This allows you to participate in its growth and financial performance if the share price rises and dividends are declared.

Let us say the shares of a company are trading at ₹500 per share.

You bought 100 shares of the company with a total investment of ₹50,000. Now, if the price of its shares rises to ₹550 per share, the value of your holding will increase to ₹55,000. But if the price falls to ₹450, your holding value will decline to ₹45,000.

In simple terms, when the share price moves up or down, the value of your investment moves with it.

Key Aspects of Equity

• Ownership: Each equity share holds a unit of ownership in the company. The percentage of your ownership depends on the number of shares you own.
• Risk and returns: The share prices can go up or down with equity market activity. A rise increases your investment value, while a fall reduces it.
• Dividends: Companies may declare dividends to share a part of their profit with the shareholders.
• Voting rights: Shareholders may also get the right to vote on some company matters. This can include voting on the appointment of the board of directors.

What is a Derivative?

Derivatives are financial contracts between two or more parties whose value depends on an underlying asset. The underlying asset can be a share, index, commodity, or currency.

Derivatives trading is based on anticipating the price movement of an asset. This allows market participants to manage the risk of an unfavourable price movement.

Main Types of Derivatives

• Futures: A futures contract is a legal obligation that binds buyers and sellers to purchase or sell an underlying asset at a predetermined price on a specified future date.
• Options: These contracts give the buyer the right to buy or sell an asset at a fixed price. The buyer is not required to exercise that right.

For example, a company expects to sell 100 tonnes of coffee beans after 3 months. The current price is ₹220 per kg, but the company is concerned that the price may fall.

So, it enters a futures contract to sell coffee at the current price after 3 months. If the market price later falls to ₹200 per kg, the gain from the futures contract can help offset the lower price received for the coffee.

This mechanism is also known as hedging, where a derivative is used to reduce the risk of an unfavourable price movement.

Key Aspects of Derivatives

• Underlying asset: The value of a derivative is based on another asset such as a share, market index, commodity, or currency.
• Expiry: Derivatives have a fixed expiry date. Once this date is reached, the contract ends and is settled based on its terms.
• Uses: Derivatives can be used to hedge against price movements or speculate on them to benefit from the price differences.
• Risk: Derivatives often use leverage. This means a small price movement can lead to a larger profit or loss.

Differences Between Equity and Derivatives

Here are the key differences between equity and derivatives:

Basis	Equity	Derivatives
Ownership	This gives you part-ownership of a company.	This does not provide ownership of the underlying asset.
Purpose	It allows you to invest in a company's growth.	This is used for hedging, speculation or arbitrage.
Losses	A fall in the share price reduces your investment value.	Losses can increase quickly when prices move against your position.
Returns	Returns may come from share price gains and dividends.	Returns may come from favourable price movements in the contract.
Risk and leverage	A fully paid share purchase does not involve leverage.	Leverage can increase both profits and losses.
Voting rights	Shareholders may get voting rights in the company.	Contract holders do not get voting rights in the underlying company.
Holding duration	Shares can be held without a fixed expiry date.	Contracts have a fixed expiry date.
Profit timing	Gains are realised when shares are sold at a higher price.	Gains or losses can arise during the contract period.