Investing in stocks without owning them
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 because for an obvious reason it is impossible for them to take a direct position on an index other than by buying each of the components of the index in exactly the same proportion as the index itself. When the index consists of 500 stocks like the SP500 this can be an insurmountable task. Futures, on the other hand, allow you to have a near perfect indexation to an index.
As with all derivatives markets, they are usually divided into two distinct families: conditional derivatives, which include warrants and options, and firm derivatives, which include equity swaps and stock index futures.
Traders use equity derivatives to speculate and manage the risks of their equity portfolios. Indeed, one of the difficulties associated with an equity investment is the ownership of that investment. 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.
Types of equity derivatives
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).
Risky because it has the potential not to be exercised and therefore to lose all the premium of the option, it allows on the other hand to offer in case of exercise an excellent leverage effect.
Warrants work like options but unlike options they are securities issued by companies (mostly banks). The range of warrants is rather reserved for retail clients because they are much less expensive than the usual options. Indeed, a warrant is usually a product that allows you to buy a portion of a share (1/10 of a share for example, which means that you have to buy 10 warrants to have the right to buy a share), while the unit of options would rather represent a right to buy 100 shares.
In a futures contract, the buyer commits to purchase the asset at a future date and at a specific price. Unlike options, in a futures contract, the buyer has an obligation to buy the asset. In simple terms, the buyer must purchase the asset on the date specified in the contract at the specified price.
Although also an interest rate instrument, convertible bonds are generally considered to be equity derivatives. Convertible bonds offer the holder the option to convert the bonds into shares of the company. In addition to the characteristics of the bond (coupon and maturity date), convertible bonds also have a conversion rate and price associated with it. Because of the conversion feature, these types of bonds pay a lower interest rate than regular bonds, making them a popular instrument for issuers.
Equity-linked swaps are generally exchanges between the performance of an index security and the receipt of payments related to fixed or floating rate securities. Short-term rates such as LIBOR or SOFR are a common benchmark for the fixed income portion of equity swaps.