Equity derivatives are financial instruments that derive value from an underlying asset, typically stocks. Equity derivatives can be traded either over-the-counter (OTC) or on exchanges in the UK.
Over-the-counter (OTC) equity derivatives trading occurs between two counterparties without going through an exchange. This type of trading is often done by large institutions such as banks and hedge funds, as it allows for a greater degree of customisation in terms of the contract.
Exchange-traded equity derivatives are standardised contracts traded on exchanges. Many brokers offer platforms to trade them, and Saxo Bank is one of them. You can learn more about CFDs by viewing the website here. These contracts are typically less complex than OTC contracts, and as a result, they may be more suitable for retail investors.
Common types of equity derivative
The most common type of equity derivative is a stock option. A stock option gives the holder the right, but not the obligation, to buy or sell a certain amount of shares of the underlying stock at a set cost (the strike cost) on or before a predetermined date (expiration date).
Another popular type of equity derivative is a stock future. A stock future is a contract that obligates the holder to buy or sell a certain number of shares of the underlying stock at a set price on a specific date.
What can equity derivatives be used for?
Equity derivatives can be used for various purposes, such as hedging or speculation.
Hedging is derivatives to offset the risk of loss from fluctuating underlying asset prices. For example, a company that produces widgets may hedge against a decline in the price of widgets by buying widget futures.
Speculation is taking a position in a derivative to profit from changes in the underlying asset price. For example, an investor may buy stock options to speculate on the stock market’s direction.
What are the risks associated with equity derivatives?
The critical risk associated with equity derivatives is counterparty risk. It is the risk that a party to a contract will not fulfil its obligations. For example, if you buy a stock option from a counterparty and the counterparty goes bankrupt, you may not be able to exercise your option.
Another risk associated with equity derivatives is the risk of loss due to changes in the underlying asset price. For example, if you buy a stock future and the price of the underlying stock declines, you will incur a loss. Another risk you should consider is the risk of expiration. If you hold a stock option that expires worthless, you will lose the premium you paid for the option.
Finally, there is the risk that the derivative itself will become worthless. It is known as basis risk. For example, if you buy a stock option and the underlying stock price does not move as expected, your option may expire worthlessly.
How can I trade equity derivatives?
If you want to trade equity derivatives, you will need to open an account with a broker that offers derivatives trading. Derivative trading is often available through online brokers.
When you have opened an account, you will need to deposit funds into your account. The amount of money you will need to deposit will depend on the broker and the type of equity derivative you want to trade.
You will then need to choose a derivative instrument and an expiration date. When choosing a derivative instrument, consider your investment objectives and risk tolerance. If you’re willing to take on more risk, you may want to consider buying stock options instead of stock futures.
Once you have chosen a derivative instrument and an expiration date, you must place your broker. Your broker will then execute the order on your behalf.
Conclusion
It is important to remember that equity derivatives are complex financial instruments, and there is a high degree of risk involved. Before trading equity derivatives, you should understand the risks and seek independent financial advice if necessary.
