Equity derivatives

What are Equity Derivatives?

Equity derivatives are financial instruments whose value is derived from the movements of a stock or a stock index. These markets are essential for investors who cannot take a direct position on an index without buying each component of that index.  Take the S&P 500 index: buying each of the 500 stocks can be an insurmountable task. Futures, on the other hand, allow near-perfect indexation to an index, therefore investing in stocks without owning them. 

How are Equity Derivatives classified?

As with all derivatives markets, they are usually divided into two distinct families: 

• Conditional derivatives, which include warrants and options;
• Firm derivatives, which include equity swaps and stock index futures. 

How do traders use Equity Derivatives?

Traders use equity derivatives to speculate and manage the risks of their equity portfolios. Equity derivatives allow the investor to buy only the performance of the underlying investment without taking ownership of a piece of the company's stock. In addition, the risks associated with equity options are much lower than those associated with owning the stock itself.

What are the main types of equity derivatives?

Options
Options give the holder the right, not the obligation:

• to buy (call option) or to sell (put option);
• at a given date or over a given period;
• a particular stock or index;
• at a given price called the strike price;
• against the payment of an immediate premium (called up front).

An option is risky because it has the potential of not being exercised therefore losing all the option premium. But if it exercised, it offers excellent leverage. 

Warrants 
Warrants work like options but, unlike options, they are securities issued by companies (mostly banks). Warrants are generally reserved for retail clients because they are much less expensive than the usual options. A warrant usually allows to buy a portion of a share (e.g.,1/10 of a share, which means that 10 warrants are needed to have the right to buy one share), while an option typically represents a right to buy 100 shares. 
Futures Contracts: In a futures contract, the buyer agrees to purchase the asset at a future date and at a specific price. Unlike options, in a futures contract, the buyer is obligated to buy the asset. Simply put, the buyer must purchase the asset on the date specified in the contract at the agreed-upon price.

Convertible Bonds
Although also an interest rate instrument, convertible bonds are generally considered equity derivatives. They offer the holder the option to convert the bonds into shares of the company. In addition to the bond characteristics (coupon and maturity date), convertible bonds also come with a conversion rate and price. Because of this conversion feature, these bonds pay a lower interest rate than regular bonds, making them popular for issuers. 
 
Equity Swaps
Equity-Linked swaps are generally exchanges between the performance-related return of a security in an index and the receipt of payments related to fixed or floating rate securities.