Derivatives are powerful assets that offer investors a lot of advantages when participating in the price action of the underlying securities. Let’s take a look at some of the most popular equity derivatives that investors use and how they work.
Options let investors to hedge risks or to speculate by taking additional risks. When you buy a call or put option, you get the right but not the obligation to buy or sell certain shares or futures contracts at a specific price before or on an expiration date.
Options go to exchanges and are centrally cleared. This provides a lot of liquidity as well as transparency, which are two important factors when taking some exposure to derivatives.
The time premium decays as the options contract comes near its expiry date. After the expiration date, the contract becomes worthless.
The intrinsic value tells whether an option is in or out of the money. When the security appreciates, the intrinsic value of an in-the-money call option also rises.
The premium that a buyer has to pay in order to acquire the option rises are volatility increases. As a result, higher volatility offers the option seller with higher income through higher premium collection.
Single Stock Futures
Meanwhile, a single stock future (SSF) is a contract to deliver 100 shares of a certain stock on a predetermined expiration date.
The SSF market price is derived from the price of the underlying security plus the carrying price of interest minus the dividend given over the term of the contract.
Trading SSF needs lower margin when compared to buying or selling the actual security. Of course, this means more leverage for the investor. Among its other advantages are:
- Cheap method to buy a stock
- Cost-efficient way to hedge for open equity positions
- Protects long-term equity position against volatility
- Long and short pairs that offers exposure to a market
- Exposure to certain economic sectors
A stock warrant gives you the right to buy a stock at a specific price at a specific time. Like call options, this one provides the investor the right to exercise stock warrants at a particular price.
Upon issuance, the price of the warrant is always higher than the underlying stock. However, it carries a long-term exercise period before they hit the expiration date.
When you exercise a stock warrant, the company gives new common shares to cover the transaction. This is different from a call option in that the call writer must offer the shares if the buyer exercises the option.
Contract for Difference
A contract for difference (CFD) is a contract between a buyer and seller that needs the seller to pay the buyer the spread between the current stock price and the price at the time of the contract if the price increases.
On the other hand, the buyer needs to pay the seller if the spread is negative. The CFD’s purpose is to let investors speculate on price movement without having to own the underlying shares.