5 Equity Derivates and How They Work

Equity derivatives are a type of investment tool that is commonly used in order to gain exposure to stock movement without actually owning the stock. The value of these derivatives is attached to the underlying stocks or indices. Here are a few of the different types of equity derivatives and how they work.

1. Stock Options

One of the most common types of equity derivatives is the stock option. A stock option is a contract that allows the owner to buy or sell a certain number of shares of stock on a specific date in the future. When you own a stock option, this gives you the opportunity to buy or sell, but you are not necessarily obligated to do so. In order to secure a stock option, you will most likely have to put up some type of option money. This will give you the ownership of the option that you can use anytime before the expiration date. If you do not exercise the stock option in that specific amount of time, it will become useless.

2. Single Stock Futures

A single stock future is another type of equity derivative and very similar to a stock option. With a single stock future, you get a contract that guarantees delivery of a fixed amount of shares of stock on a certain date in the future. You can buy these contracts for a discount from the actual price of the stock. You can also trade these contracts on the open market.

3. Warrants

Warrants are contracts that are issued directly from the company that issues the stock. These contracts are essentially like call options, as they give you the right to buy a certain number of shares of stock in the future at a certain price. The big difference with warrants is that they typically have a very long time limit associated with them. You could have a warrant that has a time limit of 15 years. If you waited 15 years from now, the stock price that you can get through the warrant will most likely be much less than what the stock is trading for in the open market. This gives investors the opportunity to realize a substantial profit in some cases.

4. Contract for Difference

A contract for difference, or CFD, is an instrument that is agreed upon between a buyer and a seller. The seller agrees to pay the buyer the amount of money that the stock price changes by over a certain amount of time. If the stock goes in the other direction, the buyer will end up paying the seller. This type of investment is not available for investors in the United States.

5. Index Return Swaps

Index return swaps are a type of agreement between two parties where two types of cash flows are traded. One may pay the total return of an index over a certain amount of time, while the other pays a specific interest rate. One of the two parties will come out ahead on this transaction. 

 

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