Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-06-15T15:54:51+05:30

Introduction

Some informed investors consider equity and derivatives as two sides of the same coin. However, on a comparative scale, derivatives are more flexible and expansive than equity. This article discusses the top differences between equity and derivatives to help you make informed decisions.

What is Equity?

Equity is a financial instrument that transfers a part of the ownership of a company to the holder of such an instrument. A company wiling to get money from the public list their shares on stock exchange(s) to carry their operations or expand their business. After listing, the shares become available to the public, and they buy or sell the shares to grow their capital. Equity is always beneficial to a company because, unlike bank loans, the company does not have to pay any interest to the public.

What are Derivatives?

Unlike equity, derivatives are financial instruments traded through stock exchanges or Over-The-Counter (OTC). While almost all equity trades occur through an exchange, derivatives trades may be executed within or without the stock exchange framework. Some types of derivatives are futures, options, forwards, and swaps. A derivative contract enables a buyer or seller to buy or sell an underlying asset (stock, index, commodity, currency, etc.) at a future date.

Now that you know the definition and primary purpose of equity and derivatives, let's understand the top differences between equity and derivatives in the following sections.

What is the Difference Between Equity and Derivatives?

Put the equity vs derivatives debate to rest with the following points:

Investment Objective

One of the top differences between equity and derivatives is that while equity stocks are a time-independent investment option, derivatives are not. Unlike equity stocks, derivative instruments come with an expiry date.

Equity stocks can be held for as long as an investor wants. Since equity stocks are a time-independent investment option, you can buy them today and sell them any day you want. You can trade equity stocks in two broad ways - intraday and positional. Intraday means buying and selling on the same day. Conversely, positional means holding on to equity stocks until your investment objectives are fulfilled.

Derivatives are of two types - standardised and OTC. Standardised derivatives like futures and options are the most common derivative types in the Indian capital market. Both futures and options are based on an underlying asset. The underlying asset may be equity stocks, indices, currencies, commodities, or even interest rates. However, you cannot hold derivatives forever. Each derivative contract comes with an expiry date, and the contract must be executed, sold, or bought before that date. If you do not sell, the contract simply expires worthless.

Hence, derivatives are best suited for people with extensive experience in the capital market, while equity stocks are for everyone.

Nature

Equity refers to a capital contribution by the business owners to the business. This may be through Initial Public Offering, Follow-on Public Offering, and the like. In contrast, derivatives derive their value from an underlying asset.

While an equity stock's performance depends on various factors, including demand and supply, financial results, macroeconomic factors, etc., equity derivatives depend on the movement of equity stocks. So, if a stock 'XYZ' is the underlying asset of a derivative instrument, the derivative may go up if the stock price increases.

Trade Equity and Derivatives Like a Professional

While predicting a winner in the equity vs derivatives debate is hard, 5paisa provides easy access to both investment instruments. Informed investors invest a part of their capital on equity stocks and the other part in derivatives. While the former gives them steady capital growth, the latter is good for hedging or short-term capital appreciation.

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