Equity Derivatives: Definition, Uses, and Examples for Effective Investment Strategies

Introduction

Have you ever thought that some investors can still make money even when the stock market is decreasing? The solution often lies in equity derivatives. So what, indeed, are equity derivatives?

Equity derivatives are financial products that derive their value from an underlying stock. They provide an opportunity to speculate on the price of a stock without owing it. This article, specifically tailored for beginners in India, will help you understand the meaning of equity derivatives, their types, their benefits and shortcomings, and much more.

Equity Derivative Types

There are several types of equity derivatives, each serving different purposes. The main types are:

1. Futures: Futures contracts are agreements to buy or sell an asset at a specified price on a stipulated date in the future. They serve as a hedge against price changes for investors and let speculators trade on price movements. They are risky because they are highly volatile but rewarding when used strategically to manage risk and lock prices.

2. Options: Options provide the right, but not the obligation, to buy (call option) or sell (put option) a stock at a predetermined price (strike price) before or at expiry. It’s important to note that when trading options, you purchase the option contract itself, not the actual stock. This will allow you to profit from market movements without owning the stock.

• Call Options are typically used when you expect the underlying asset's price to rise.
• Put Options are used when you expect the price of an underlying asset to fall.

3. Warrants: Warrants resemble options but are generally issued by companies. They grant you the privilege to purchase the company's stock at a fixed price (exercise price) before expiration. For example, a company could award warrants to draw investors in, giving the latter a potential future stake in the business.

4. Swaps: Swaps are financial agreements where two parties exchange cash flows based on the performance of different assets or indices.

Equity swaps are used for several reasons. Some of them are:

• Hedging: To protect against losses in other investments.
• Speculation: To bet on the future performance of stocks without owning them.
• Customizing Exposure: To tailor investments to specific market segments or strategies.

Swaps help manage risk and diversify investments across different markets, allowing investors to gain or limit exposure without directly buying or selling the underlying assets.

Also Read: 5 Reasons To Invest In Equity Market

Advantages of Equity Derivatives

Equity derivatives offer several benefits:

1. Hedging: Equity derivatives allow investors to protect their portfolios from potential losses. For instance, if you own shares of a company and fear a price drop, you can use derivatives like futures or options to hedge against this risk. By doing so, you minimise potential losses.

2. Leverage: Derivatives, known as leverage, can control a larger position with less capital. For example, instead of paying the full price for 100 company shares, you can use a fraction of that amount to gain exposure to those shares through derivatives. This can lead to higher returns if the market moves in your favour. However, remember that leverage also increases the potential for losses.

3. Flexibility: Equity derivatives provide flexibility in your investment strategy. You can use them in various market conditions – whether the market is going up, down, or flat. For instance, call options can be used to profit from rising prices, while put options can benefit from falling prices. This adaptability helps investors adjust their strategies based on their market outlook.

4. Liquidity: The equity derivatives market is usually very liquid, meaning many buyers and sellers actively trade these instruments. This high liquidity ensures that investors can easily enter and exit positions without significant price impact, facilitating efficient execution of trading strategies.

Disadvantages of Equity Derivatives

Despite their benefits, equity derivatives have some drawbacks:

1. Complexity: Equity derivatives can be quite complex and require a good understanding of how they work. Unlike regular stock trading, derivatives involve factors like strike prices, expiration dates, and margin requirements. This complexity can be overwhelming for novice investors and lead to mistakes. Educating yourself thoroughly or seeking advice from financial experts before trading derivatives is essential.

2. Risk of Loss: While derivatives offer the potential for higher returns, they also expose investors to significant risks. Using leverage to control larger positions can amplify potential gains but also magnify losses if the market moves against the investor's position. Therefore, managing risk and establishing clear risk management strategies are crucial to mitigate potential losses and protect your investments.

3. Costs: Trading equity derivatives typically incur higher transaction costs than regular stock trading. These costs include brokerage fees, margin requirements, and other transaction-related expenses. Frequent trading or managing large positions can lead to substantial cumulative costs, thereby impacting overall profitability. Therefore, it is essential to factor these costs into your trading strategies.

Risks Associated With Equity Derivatives

Investing in equity derivatives comes with several risks:

Counterparty Risk

Counterparty risk arises if, for example, a trading partner defaults on a derivative contract. In India, a clearing corporation acts as a middleman to manage this risk for exchange-traded equity derivatives. The clearing corporation ensures both parties meet their obligations, stepping in if one defaults, thus reducing counterparty risk and maintaining market stability.

Price Risk

Price risk is the risk of losing money because the price of an asset changes. For example, if you buy a stock at ₹100 and its price drops to ₹80, you face price risk. This is common in investments like stocks, bonds, and commodities, where prices fluctuate due to market conditions.

Agency Risk

Agency risk occurs when the people managing your investments act in their own interest rather than yours. Think of it like hiring someone to manage your business, but they make decisions that benefit them more than you. In finance, this can happen with fund managers or corporate executives.

Systemic Risk

Systemic risk is when a failure in one part of the financial system can cause a domino effect, impacting the whole system. An example is the 2008 financial crisis, where problems in the housing market led to widespread economic turmoil. It's like one bad apple spoiling the whole basket.

Liquidity Risk

Liquidity risk is the difficulty of selling an asset quickly without losing value. Finding a buyer at a fair price might be hard if you own a rare painting and need cash urgently. In financial markets, this risk affects assets like real estate or certain bonds that can't be easily converted to cash.

Who Should Invest in Equity Derivatives?

Equity derivatives are not for everyone. Here’s an example to help you understand if it’s for you.

Rahul, a seasoned investor, enjoys the thrill of high-risk investments and deeply understands complex financial instruments. He spends hours daily monitoring the market, making quick, informed decisions without letting emotions cloud his judgment. Equity derivatives suit him perfectly. Even experienced investors like Rahul need to manage risk carefully when trading derivatives. Managing risk effectively can prevent significant losses and ensure long-term success in the market.

Investors like Rahul, who have a high tolerance for risk, substantial market knowledge, and the time to actively manage their investments, should consider equity derivatives. These investors are the ones who are fine with a possible loss for a chance of better return and can keep their calm during market roller coasters. If you can identify with this description, equity derivatives could be your thing.

On the other hand, Priya, who is new to investing, finds derivatives too complicated and time-consuming and prefers safer investments.

With their demanding jobs, Arjun and Meera, who prefer stability and calm, both realise that equity derivatives' fast-paced, volatile nature isn’t for them. Equity derivatives might not suit you if you have low-risk tolerance, limited market knowledge, or cannot dedicate time to active trading.