Equity derivatives derive their value from an underlying equity, which can be a stock or an equity index. This provides the investor with an opportunity to bet on or hedge out movements in the prices of stocks without ever needing to hold the stocks. There are different types of equity derivatives, such as options, futures, and swaps. They find vast usage by both individual investors as well as institutions and financial firms. Below, we provide a comprehensive guide to understanding equity derivatives, types, uses, benefits, risks, and strategies.
1. Definition
An equity derivative is a contract between two or more parties based on an underlying stock or stock index stock price. This class of instruments simply means that investors can take advantage of the movement of the price of the underlying asset without owning it. Another way in which investors can bet on changes in the prices of shares is by using equity derivatives, which may gain from either a rise or fall in value at a relatively low cost, taking perhaps only a portion of the capital, they might need to purchase or sell shares outright.
2. Classifications of Equity Derivatives
There are several classifications of equity derivatives, and each has distinct characteristics along with its own purposes:
a) Equity Options
Call Options: A call option is an option that gives the holder the right but not the obligation to buy a particular stock at a predefined price called the strike price during some predefined time. An investor buys a call option when he or she believes that the price of the particular stock will increase.
Put Options: A put option gives the buyer the right to sell a specific share of stock at a mutually agreed strike price on or before an agreed date. Investors buy a put option when they expect that stock price will decline.
Options are as popular for their leverage element: this means an investor may have control over a larger part of a stock with lesser capital outlay, but there is risk involved as well-the underlying option might expire worthless.
b) Equity Futures
Equity futures are standardized contracts to buy or sell stock or a stock index at a stipulated price on a specified future date. Unlike options, futures contracts obligate both parties to fulfill the contract on the expiration date.
Futures are often used to hedge against price moves or to speculate on a stock’s future price. Equity index futures (such as S&P 500 or Nifty 50) are widely traded and give investor broad exposure to the market.
c) Equity Swaps
An equity swap is defined as a derivative in which two parties agree to exchange future cash flows based on an underlying equity or index. In an equity swap, one leg of the cash flow typically is based on the return of an equity asset-a dividend and capital gain-and the other is based on a fixed or floating interest rate.
Swaps are heavily used for institutional investors in terms of customized exposure or to hedge portfolio risk.
3. Principal Application of Equity Derivatives
Equity derivatives are applied for different purposes, primarily speculation, hedging and arbitrage.
a) Speculation
Investors and traders utilize derivatives to speculate on the movement of stock prices without buying or selling the stocks. Future and Options provide leveraged exposures to stocks, meaning that investors can magnify their returns (and losses) using a much more modest amount of capital.
For example, a trader who expects a stock price to rise may buy call options on the stock to profit from the expected increase.
b) Hedging
Derivatives are often employed as hedging tools in the minimization of price shocks risk. For example, an investor who owns an equity can buy put options on the same equity to hedge against potential losses in case the price of the equity falls.
Hedging with derivatives is most ideally helpful to institutional investors and corporate entities in managing risks exposures without selling their underlying positions.
c) Arbitrage
Arbitrage is taking the difference of price levels on related assets to obtain a return. An example is that if the futures price of a stock is greater than its spot price, then an investor would sell the futures and simultaneously buy the stock, which means that he will gain profit by locking in the differences.
Working professionals as well as institutions frequently use arbitrage strategies within equity derivative markets for price arbitrage of asset prices between markets.
4. Benefits from using Equity Derivatives
Leverage: Derivatives enable the investor to control significant amounts of stock for a small percent of the price, magnifying both profits and losses. This enables investors to use their capital much more efficiently.
Risk Management: Equity derivatives are some of the best instruments that provide risk management and risk mitigation, and help investors defend their portfolios against adverse movements in price.
Market Access: Derivatives provide access to a broader range of investment opportunities, such as international markets, sectors, and indices, which would be harder to access directly.
Potential for Returns: An investor has the opportunity for taking advantage of an upward or downward movement in stock prices through speculation, if the investor adopts the right derivatives strategy, for instance, by purchasing calls or puts.
5. Equity Derivatives Risks
Leverage Risk: Derivatives have leverage which in itself is a source of significant loss. Though investors have committed hardly a fraction of a percentage to total exposure, if the markets move against their position, that fraction gets magnified into huge loss.
Market Risk: Equity derivatives tend to be sensitive to market movements and these markets can be extremely volatile. Such risks are there mainly for speculative positions.
Time Decay: Options have a time element and their value decay as they near expiration. Investors who do not take into consideration time-sensitive options may lose in the last days to expiration.
Liquidity Risk: Some derivatives might not be as liquid as others. This implies that investors may find it challenging to enter or leave their positions without having a drastic effect on price.
Counterparty Risk: Over-the-counter derivatives, such as equity swaps, are susceptible to counterparty risk that might arise from one party’s failure to meet its terms of contractual obligations.
6. Highly Popular Strategies in Equity Derivatives
Covered Call writing: Investors purchase a call on shares they already have. When the stock price is low, this call option acts like an umbrella, which enables the investor to control his or her losses.
Covered Call: This is an example when an investor owning a stock sell call options on such a stock. The investor earns the income from the premium of the call options and, at the same time, benefits from moderate appreciation in the stock price.
Straddle and Strangle: These are volatility plays wherein investors purchase both a call and a put option on the same stock at different or the same strike prices. They earn in such situations when the stock price moves considerably in either direction.
Bull and Bear Spreads: These are those strategies in which options are bought and sold with the intention of making profit out of the small prices movements in either direction. Bull spreads are used in case of an upward movement, while bear spreads are used in case of an anticipated decline.
Calendar Spread: This strategy involves the purchase and selling of different expiration dates options. Investors can hence capitalize on the expected changes in volatility or time decay through this strategy.
7. Equity Derivatives Markets in India
The national equity derivatives markets are available on the National Stock Exchange and Bombay Stock Exchange in India. Both have a broad range of derivative products, including index options, stock options, index futures, and stock futures. It involves a regulatory authority in conducting or supervising the derivatives of the country with a motive of stabilization, transparency, and protection of investors called the Securities and Exchange Board of India (SEBI).
Index derivatives are actually the most traded derivatives in India and particularly on the indices of Nifty 50 and Bank Nifty. This instrument may be an avenue to obtain exposure to broad movements in the market and to hedge portfolio risk. Options and futures available on individual stocks are also possible through the NSE, offering more flexibility to the investor.
Conclusion
The equity derivative is a very potent financial instrument with scope for speculation, hedging, and arbitrage opportunities that are offered to both individual and institutional investors. The derivatives instruments are highly flexible with an all-around flexibility while taking an advantage of the capital efficiency, but the leverage and market dynamics of equity derivatives introduces many risks that must be effectively managed and understood. The equity derivatives in India are, therefore, an integral part of the financial markets, permitting investors to enhance returns, diversify strategies, and manage portfolio risks.