An Equity derivative is a derivative instrument with underlying assets based on equity securities. The value will fluctuate with changes in its underlying asset’s equity, which is usually measured by share price. Equity derivatives can be used to hedge the risk associated with taking a position in stock by setting limits to the losses incurred by either a short or long position in a company’s shares. The investor receives this insurance by paying the cost of the derivative contract, which is referred to as a premium. In case of purchases of stock, a loss in share value by purchasing a put option can be protected. On the other hand, if the investor has shorted shares, he or she can hedge against a gain in share price by purchasing a call option.
Options are the most common equity derivatives because they directly grant the holder the right to buy or sell equity at a predetermined value. More complex equity derivatives include equity index swaps, convertible bonds or stock index futures.
Types of Equity Derivatives:
Equity options
Equity options are the most common type of equity derivative. They provide the right, but not the obligation, to buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of stock), at a set price (strike price), within a certain period of time (prior to the expiration date).
Warrants
A warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is much higher than the stock price at time of issue. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers.
Convertible bonds
Convertible bonds are bonds that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio. It is a hybrid security with debt- and equity-like features. It can be used by investors to obtain the upside of equity-like returns while protecting the downside with regular bond-like coupons.
Equity futures, options and swaps
Investors can gain exposure to the equity markets using futures, options and swaps. These can be done on single stocks, a customized basket of stocks or on an index of stocks. These equity derivatives derive their value from the price of the underlying stock or stocks.
Exchange-traded derivatives
Other examples of equity derivative securities include exchange-traded funds etc.