Equity derivatives are instruments with underlying assets based on equity securities. Their values fluctuate with changes in their underlying assets’ equity, which is usually measured by share price. The most common equity derivatives are options and futures.
The most important aspect of equity derivatives are that they allow traders to transfer risks associated with the underlying securities. This is usually done by buying or selling options or combinations of options against the cash or futures of the underlying security, the vast majority of which are traded on the stock exchanges. Alternatively, market counterparties can also trade such products against each other on an OTC or off-exchange basis.
These are the most common type of equity derivatives. They provide a trader the right, to buy or sell a quantity of stock at a set price within a certain period of time but before the expiry date.
Convertible bonds can be converted into shares in the issuing company, usually at a pre-determined ratio. They are also called hybrid securities as they have both features of debt and equity. Investors can use them to obtain the benefit of equity-like returns while safeguarding the drawback with regular bond-like coupons.
Stock market index futures
These can be used to reproduce the performance of an underlying stock market index. These contracts can also be used for hedging against an existing equity position as well as for or speculating on the index’s future movements.
Equity basket derivatives
These consist of more than one stock or stock market index. The baskets can be composed of stocks from one or more industries while they can also be designed to replicate broad market indices. In the latter case, a basket may be used rather than the full index because some index components do not trade actively.