You probably have encountered those investors who make moves in the stock market without actually owning any stocks. There are no underlying tricks; equity derivatives are at play.
Equity derivatives give you a lot of flexibility, whether you’re looking for ways to protect your investments or take advantage of market ups and downs. But before jumping in, it’s essential to know what they are and how they work.
In this blog post, in order for you to make smarter choices, we’ll break down the basics, cover the different types, and go over the pros and cons.
What are Equity Derivatives?
The history of derivatives goes way back. There’s a story about the philosopher Thales of Miletus, who lived around 600 BC. While he didn’t own any olive presses, he predicted a big olive harvest. He made deals with the owners of the presses to rent them at a set price when the harvest came. The prediction came true, and Thales rented out the presses at a higher price and profited from it.
Now, let’s say you want to make some money in the stock market. However, like Thales, you don’t actually buy the actual shares of a company. Instead, you use a special kind of contract. This contract would gain its value from that stock. If the stock goes up or down, so does the value of your contract.
These contracts are called equity derivatives. Equity derivatives are financial tools whose value comes from the price of an underlying equity, such as a stock or bundle of stocks.
There are a few reasons why equity derivative trading has gained popularity over the past few years. Some of the most important examples are protecting their portfolios, betting on future price changes, or controlling more prominent positions with less money upfront.
Types of Equity Derivatives
Equity derivatives have many forms, but the most common types of them are options and futures.
Stock Options
With an option, you’re able to buy or sell a stock at a set price (strike price), but first, you pay a small amount of upfront money (a premium) to secure this right. Also, there’s an expiration date for this contract. There are two kinds of stock options: call option and put option.
- You can secure your right to buy a stock by using the call option at a certain price before a specific date. If you believe the stock price is going to rise, one strategy is to purchase a call option. For example, you buy a call option for Company X with a strike price of $10, and you pay a premium of $1 for that option. This means you have the right to buy their stock for $10 at any time before the option expires. If the stock price rises, you can buy the stock for $10 and immediately sell it for a higher price.
- The Put Option is similar to the call option, with the only difference being that you have the right to sell that stock you just bought before the expiration date. When the stock goes down, your put option becomes more valuable. It is because it lets you sell the stock for more than its current worth on the market.
Stock Futures
Futures are contracts with which you are obliged to buy or sell a stock at a set price on a specific date in the future. Unlike options, you are obligated to complete the transaction when the contract expires.
Pros and Cons of Equity Derivative Trading
Equity derivatives offer several advantages, including high potential ROIs, hedging risks, and gaining access to a larger amount of stock with a smaller initial investment.
For example, one strategy to avoid capital losses is to buy a put option for your stock if you own a share and are concerned the price might drop.
However, there’s always a downside. Equity derivatives may require experience and be a bit tricky for newcomers. This heightens the fact that you should always be aware of their high-risk nature. It’s essential to keep the liquidity risk of some equity derivatives in mind, particularly in less active equity derivative markets. This situation can make it difficult to exit a position quickly, which could result in a significant loss. Make sure you fully understand these new concepts and educate yourself before diving in!
How are Equity Derivatives Traded?
Exchange-Traded Equity Derivatives
Exchange-traded derivatives are standardized contracts that are bought and sold on exchanges such as the CBOE or the NYSE.
To get started, You need to open an account with a broker that provides access to derivatives markets. After you decide whether you want to trade options, futures, or other derivatives, you pick the underlying asset, expiration date, and strike price. By using your brokerage platform, you can place an order, and once the order goes through, voila, you’ve got yourself a position in that derivative.
Since exchanges are monitored by authorities, the whole process is done with such transparency. A clearing house steps in to make sure both sides of the deal stick to their end, which would consequently help to lower the risks.
Over-the-Counter (OTC) Equity Derivatives
Over-the-counter (OTC) derivatives trade requires the direct involvement of two parties, usually big players like commercial banks, hedge funds, or government-sponsored enterprises.
In order to start trading, you first have to work out the details directly with the other side. In OTC tradings, both parties mutually agree on various conditions, including the contract terms, notional amount, underlying assets, and payment dates.
Finally, The deal is done privately, with both parties sorting out payment flows and settlement terms. However, the downside is that since there’s no central authority monitoring the trade, there’s a risk that one side might not hold up their end of the deal.
Conclusion
Understanding equity derivatives trading strategies has proved to be a handy tool in finance. Yet, they’re not something to dive into without prior knowledge. From options and futures on public exchanges to custom deals made in OTC markets, there are lots of opportunities, but a good grasp of the details is required. So, whether you’re hedging a portfolio or betting on price swings, it’s wise to get the basics down first. When used right, they can be a solid part of your investment plan.
Equity derivatives derive value from the price of a stock or index. Investors use them to speculate or protect their portfolios.
Stock options let you choose to buy or sell. Futures force you to buy or sell at a set price on a future date.
Pros: High returns and risk management. Cons: Complex, risky, and sometimes hard to exit.
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