EN
Equity derivatives are financial instruments whose value is derived from underlying stocks or equity indices. They serve various purposes for investors and traders, including risk management, speculation, and portfolio optimisation. Derivatives allow traders to bid on the direction of the underlying asset’s price change without owning it.
Key Takeaways
-
Equity derivatives are financial contracts that derive value from stocks, enabling investors to hedge, speculate, and leverage capital without owning underlying assets.
-
Futures, options, swaps, and forwards are common types that traders use to manage risk and enhance returns with various strategies dependent on price direction and time.
-
While derivatives offer advantages like leverage, diversification, and liquidity, they also involve risks such as market volatility, time decay, counterparty default, and margin calls.
-
Equity derivatives are better suited for experienced investors and institutions with strong market knowledge, clear strategies, and risk control, rather than beginners.
How are Equity Derivatives Traded?
Equity derivatives trading in India takes place in two primary markets: exchange-traded markets, which are standardised and regulated (like NSE and BSE), and over-the-counter markets, which involve customised and privately negotiated contracts.
In exchange-traded markets, equity derivatives trading takes place on a formal platform between buyers and sellers, and clearing houses such as National Securities Clearing Corporation Limited (NSCCL) act as a central counterparty to secure settlement. Over-the-counter markets are more direct, bilateral agreements between parties, such as forwards and swaps.
Also, learn How to Buy OTC Stocks here.
Equity Derivative Types
Equity and derivatives are available in many forms, with each having a different trading and investment purpose.
Futures Contracts
Futures are standardised contracts traded on an exchange that bind the parties to either purchase or dispose of equity assets at a fixed price with a specified date. They are typically utilised to hedge or even bet on the future change of stocks or indices. Equity index futures, like the BSE S&P and Nifty IT, are popular examples.
Options
Options give the right, but not an obligation, to buy or sell an underlying stock or index at a specified price before or on a specific expiration date. They are flexible in hedging or speculative. Two major types of stock options are:
-
Call Options: Give holders the right to purchase shares at a certain price.
-
Put Options: Give holders the right to sell stocks at a given price.
Forwards
Forwards are similar to futures, where the parties are obligated to perform the contract. But forwards are non-standardised, over-the-counter contracts that don’t trade on the stock exchanges.
Swaps
Equity swaps are the exchange of cash flows based on equity returns for interest or another equity index, and they are beneficial for risk management.
Warrants & Convertible Bonds
The warrant provides the long-term rights to buy the shares of the company at a predetermined price. Convertible bonds combine debt and equity, allowing holders to convert them into company shares in the future under certain predetermined conditions.
Also, check out OTC Options here.
Advantages of Equity Derivatives
Trading with equity derivatives offers several advantages:
-
Risk Management: Equity derivatives provide practical tools for hedging against price fluctuations in the equity markets. Investors can use options and futures contracts to protect their portfolios from adverse market movements.
-
Leverage: Equity derivatives typically require a smaller upfront investment compared to buying the underlying assets directly. This leverage allows traders to control a larger position with a smaller capital outlay, potentially magnifying profits (but also losses).
-
Diversification: Derivatives allow investors to gain exposure to a wide range of equities or equity indices without buying individual stocks. This diversification can help spread risk across various assets.
-
Liquidity: Many equity derivatives markets are highly liquid, allowing for easy entry and exit positions. This liquidity ensures that traders can typically find a counterparty to trade with, reducing the risk of illiquidity.
-
Speculation: Traders use equity derivatives to speculate on price movements. They can profit from both rising (by buying call options) and falling (by buying put options) markets, offering opportunities in various market conditions.
-
Cost-efficiency: Derivatives can be a cost-effective way to gain exposure to equity markets, as they often involve lower transaction costs than buying and selling individual stocks.
-
Portfolio optimisation: Equity derivatives enable portfolio managers to adjust their asset allocation, manage risk, and enhance returns through options and futures strategies.
-
Arbitrage opportunities: Traders can exploit price discrepancies between derivatives and their underlying assets, helping keep markets efficient.
-
Flexibility: A wide variety of equity derivatives is available, catering to different risk profiles and investment strategies. This flexibility allows investors to tailor their positions to meet specific objectives.
-
Income generation: Options sellers can generate income through premium collection, which can enhance overall portfolio returns.
Disadvantages of Equity Derivatives
Equity derivatives provide various benefits, but they also come with several disadvantages and risks that investors, traders, and institutions should be aware of:
-
Leverage risk: One of the most significant drawbacks of equity derivatives is the potential for magnified losses due to leverage. Leverage can amplify both gains and losses, leading to substantial financial risks.
-
Complexity: Derivative instruments can be complex, with intricate pricing models and strategies. This complexity can make them challenging for inexperienced investors to understand and utilise effectively.
-
Risk of loss: Equity derivatives can lead to significant financial losses if market movements go against the investor's position. This risk is particularly high when using options, as the entire premium paid can be lost if the option expires worthless.
-
Time decay: Options contracts have a finite lifespan, and their value erodes over time, which is known as time decay. This can lead to losses for option buyers if the market doesn't move in the desired direction quickly enough.
-
Counterparty risk: In over-the-counter (OTC) derivative markets, there is a counterparty risk. If the counterparty defaults on its obligations, it can result in substantial losses for the other party.
-
Market risk: Equity derivatives are subject to market risk, including changes in stock prices, volatility, and overall market conditions. These factors can impact the value of derivative positions.
-
Illiquidity: While many equity derivatives markets are highly liquid, some specific contracts or assets may lack liquidity. This can make it challenging to execute trades at desired prices.
-
Margin calls: When using leverage, investors may be required to meet margin calls if their positions move against them. Failure to meet margin requirements can lead to forced liquidation of positions.
-
Regulatory changes: Government regulations related to derivatives can change, affecting how these instruments are traded, taxed, or regulated. Investors must stay informed about these changes.
-
Psychological stress: Trading in equity derivatives can be emotionally taxing, as market volatility and the potential for rapid losses can lead to stress and anxiety for traders and investors.
-
Limited ownership rights: Equity derivatives do not provide ownership rights in the underlying assets. Unlike owning actual stocks, derivative holders do not receive dividends or voting privileges.
-
Costs: Transaction costs, including commissions and fees, can erode profits, especially for frequent traders.
-
Overtrading: The ease of trading derivatives can lead some investors to overtrade, which can result in higher transaction costs and increased exposure to risk.
Risks Associated With Equity Derivatives
-
Leverage risk: Equity derivatives often involve leverage, so a small price movement in the underlying asset can affect the value. So, while leverage can amplify profits, it can also magnify losses, potentially exceeding the initial investment.
-
Market risk: Equity derivatives are highly sensitive to changes in the underlying asset's price. Market risk includes the risk of adverse price movements, volatility, and unexpected market events that can impact the value of derivative positions.
-
Counterparty risk: In over-the-counter (OTC) derivative markets, there's counterparty risk. If the other party involved in the trade defaults on its obligations, the investor could suffer significant losses. This risk can be mitigated by trading on regulated exchanges.
-
Liquidity risk: While major equity derivatives markets are liquid, specific contracts or less popular assets may lack liquidity. The lack of liquidity can make it difficult to execute trades at desired prices, potentially leading to losses.
-
Time decay: Options contracts have finite lifespans, and their value erodes over time, primarily due to time decay. This poses a risk for option buyers, who may see their positions decline in value even if the underlying asset's price remains unchanged.
-
Regulatory risk: Government regulations and tax laws regarding derivatives can change, impacting how these instruments are traded, taxed, or reported. Investors must stay informed about regulatory changes that could affect their positions.
-
Psychological stress: Trading in equity derivatives can be emotionally taxing due to the potential for rapid losses and market volatility. Emotional reactions can lead to impulsive decisions and poor risk management.
-
Complexity risk: Derivative instruments can be complex, requiring a deep understanding of pricing models and strategies. Investors who do not fully comprehend these complexities are at risk of making costly mistakes.
-
Margin calls: When using leverage, investors may be required to meet margin calls if their positions move against them. Failure to meet margin requirements can result in the forced liquidation of positions.
Who Should Invest in Equity Derivatives?
Equity derivatives trading is suitable for investors who understand the derivatives market and the risks associated with equity market volatility. Traders in the derivatives market should have a clear investment strategy and risk management plan. Traders, institutional investors, and those seeking portfolio diversification or hedging against market volatility can benefit from equity derivatives. Novice investors should consider gaining experience in traditional equity investments before venturing into derivatives or seek professional advice to minimise risks.
Why Invest in an Equity Derivative?
Equity derivatives investments are useful in risk management in order to hedge, speculate on price variations, and capital leverage to have higher returns with less capital. Equity derivative investments are also cost-effective, have liquidity and diversification without necessarily having to own the underlying stocks.
The following are some of the reasons why one should invest in the equity derivatives market:
-
Risk management: Equity derivatives can be applied as an insurance cover to a portfolio against a setback in price.
-
Speculation: Traders and investors may use equity derivatives to speculate as to whether the price of the underlying asset will increase or decrease.
-
Leverage: Investors have the opportunity to get a huge exposure to an asset at a relatively low investment.
-
Cost efficiency: Equity derivatives are cheap, where the cost of transacting the derivatives is usually lower compared with purchasing or selling the stocks underlying the derivatives.
-
Diversification: The huge exposure to a vast range of equities can be obtained by investors and traders without the need to purchase each stock.
-
Liquidity: Some equity derivative markets, particularly major index derivative markets, are very liquid, implying that entering and leaving positions are easy.
Differences Between Equity and Index Derivatives
Index derivatives are primarily futures contracts with indices as underlying assets.The following table shows the differences between equity and index derivatives.
|
Areas of Comparison |
Equity Derivatives |
Index Derivatives |
|
Underlying assets |
Stocks of listed companies |
Indexes such as NIFTY50, Bank Nifty, etc. |
|
Expiry |
Monthly expiring contracts |
Monthly and weekly expiring contracts |
|
Cash settlement |
Possible, generally takes t+1 days |
Possible, generally takes t+1 days |
|
Physical settlements |
Physical settlement is possible, but only if it’s not executed until the expiration of the contract. |
Not available |
Final Words
Equity derivatives are types of financial contracts with equity as the underlying asset. Though have the potential to magnify the returns, they also carry considerable risk. So, it’s crucial to employ necessary risk management strategies and understand the instrument properly before investing or trading. If you want to trade in equity derivatives, open a trading account with Angel One for free.