An equity derivative is an item with a value that is derived from another form of security. This derivative is typically in the form of an agreement regarding an item with value. That agreement is the equity derivative, not the valuable item. As the value of the derived item fluctuates, the value of the equity derivative fluctuates as well. There are two common types of derivatives—futures and options—, but nearly anything may be traded as an equity derivative.
A typical derivative is an agreement regarding a valuable item called an underlying. The underlying is given a fixed value at the time of the contract signing. As the price of the underlying fluctuates, the contract gains or loses value. If the underlying’s price goes up, the contract is more valuable since the contract price is lower; if the underlying’s price drops, the contract loses value.
The buying and selling of derivatives is a major part of the financial world. Contracts are drawn up and sold on the primary market and then sold many times over on the secondary market. The contracts represent potential income, the ability to make a guaranteed amount of money should the market remain stable.
The most common forms of equity derivative are options and futures. An option is one of the most general forms of derivative. It is the option to buy or sell a stock some time in the future, before the expiration on the option. The broad terms of an option allow it to generate a lot of money if used at the right time, but after its expiration it is totally worthless.
A future is similar to a bet on the future amount of a raw material or commodity. The contract associated with a future is centered on a good to be delivered at a later time. If there is a shortage of the good, the value of the future goes up. When there is a surplus, the value of the future goes down.
Outside of options and futures, there are other less common forms of equity derivatives. Warrants and convertible bonds are contracts for selling stock outside of normal channels. A warrant allows a buyer to purchase stock at a highly reduced rate. A convertible bond allows a bond holder to transform the bond into stocks.
All of these types of derivatives have an underlying item of value. In options, warrants and convertible bonds, it is the stock of the specified company. When dealing with futures, it is the value of the traded good. Anything that has a value on the exchange may have a derivative contract based on it. As a result, anything of value may be turned into the underlying for an equity derivative.