Derivatives Vs. Options

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In financean equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively traded. Equity options are the most common type of equity derivative. In financea warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is much lower than the stock price at time of issue.

Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Convertible bonds are bonds that can be converted into shares of stock in the issuing companyusually at some pre-announced ratio. It is a hybrid security with debt- and equity-like features.

It can be used by investors to obtain the upside of equity-like returns while protecting the downside with regular bond-like coupons. Investors can gain exposure to the equity markets using futures, options and swaps. These can be done on single stocks, a customized basket of stocks or on an index of stocks. These equity derivatives derive their value from the price of the underlying stock or stocks. Stock markets index futures are futures contracts used to replicate the performance of an underlying stock market index.

They can be used for hedging against an existing equity position, or speculating on future movements of the index. Indices for OTC products are broadly similar, but offer more flexibility. Equity basket derivatives are futures, options or swaps where the underlying is a non-index basket of shares. They have similar characteristics to equity index derivatives, but are always traded OTC over the counter, i. Single-stock futures are exchange-traded difference between derivative future and option trading contracts based on an difference between derivative future and option trading underlying security rather than a stock index.

Their performance is similar to that of the underlying equity itself, although difference between derivative future and option trading futures contracts they are usually traded with greater leverage. Another difference is that holders of long positions in single stock futures typically do not receive dividends and holders of short positions do not pay dividends.

Single-stock futures may be cash-settled difference between derivative future and option trading physically settled by the transfer of the underlying stocks at expiration, although in the United States only physical settlement is used to avoid speculation in the market.

An equity index swap is an agreement between two parties to swap two sets of cash flows difference between derivative future and option trading predetermined dates for an agreed number of years. Swaps can be considered a relatively straightforward way of gaining exposure to a usd cad chart forexpro asset class.

They can also be relatively cost efficient. An equity swap, like an equity index swap, is an agreement between two parties to swap two sets of cash flows. In this case the cash flows will be the price of an underlying stock value swapped, for instance, with LIBOR. A typical example of this type of derivative is the Contract for difference CFD where one party gains exposure to a share price without buying or selling the underlying difference between derivative future and option trading making it relatively cost efficient as well as making it relatively easy to transact.

Other examples of equity derivative securities include exchange-traded funds and Intellidexes. From Wikipedia, the free encyclopedia. Stock market index future. Energy derivative Freight derivative Inflation derivative Property derivative Weather derivative. Retrieved from " https: Derivatives finance Options finance. All Wikipedia articles needing clarification Wikipedia articles needing clarification from March All accuracy disputes Articles with disputed statements from November Views Read Edit View history.

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Options and futures are both commonly used trading tools in the world of investment and finance. Trading either of them is a little more complicated than simply buying stocks which is a form of investment that many people have at least a basic understanding of. Used correctly, they both offer plenty of opportunities for making money. Options and futures are both widely used to benefit from leverage and they are also both useful tools for hedging purposes.

However options and futures are actually very different from each other. This can be a very costly mistake, and no one should ever get involved with any kind of financial trading or investment without knowing exactly what they are doing. On this page we highlight the similarities between options and futures, look at the main difference between the two, and explain why we believe options trading offers many advantages.

It should be made clear that there are certain similarities between options and futures, and it is understandable how even relatively experienced investors can get the two confused. They are both financial contracts that exist between two parties — the buyer and seller of an underlying asset. They can both be traded on public exchanges, although some of the more complex contracts are only sold over the counter. They are also both leveraged derivatives — although if you know what this means the chances are that you can already recognize the difference between the two.

Basically, a derivative is a financial instrument that derives its value primarily from one or more underlying asset. Leverage is a term for any technique that you use to effectively multiply the power of your capital. For example, if you buy stocks in a company then you physically own a share in that company and the asset you own can go up or down in value. When buying a derivative, you are buying a contract which is valued according to the underlying asset on which it's based and possibly other factors such as the length of the contract.

Leverage is when you effectively multiply the power of the cash you are investing to generate larger returns; this is possible with both options and futures and is the main reason why they are known as leverage derivatives. The fundamental difference between options and futures is in the obligations of the parties involved. The holder of an options contract has the right to buy the underlying asset at a fixed price, but not the obligation. The writer, or seller, of the contract is obligated to sell the holder the underlying security or buy it , if the holder does choose to exercise their option.

This obviously puts the holder of a contract at an advantage, because if the underlying security moves against them, they can simply let the contract expire and not incur any losses over and above the original cost.

If the underlying security moves in the right direction for the holder and therefore against the writer , then the writer must honor their obligation. In a futures contract, both parties are obliged to fulfill the terms of the contract at the point of expiration. This is a very significant difference.

Buying a futures contract where you will be obliged to buy a particular security at a fixed price carries much more risk than buying an options contract where you have the right to buy a particular security at a fixed price, but are not obliged to go through with it if that security fails to move up in value as you expect. Both parties involved in a futures contract are effectively exposed to unlimited liability.

The costs involved are also different. When an options contract is first written, the writer of it sells it to the buyer and receives the money that the buyer pays. Depending on the terms of the contract, the underlying security involved, and the circumstances of the writer, the writer may have to have a certain amount of margin on hand. They may also be required to top up that margin if the underlying security moves against them. However, the buyer owns those contracts outright and no further funds will be required from them.

With futures, though, as both parties are exposed to losses depending on which way the price of the underlying security moves, they are both required to have a certain amount of margin on hand. Price differences on futures are settled daily, and either party could be subject to a margin call if the value of the underlying security has moved against them. This contributes largely to why futures trading is generally considered riskier than options trading.

Below we look at a couple of the advantages trading options has to offer. As mentioned above, when trading futures you are potentially exposed to big losses whichever side of the contract you are on. If you have the obligation to buy an underlying security at a fixed price and the security moves significantly above that fixed price, then you could lose substantial sums.

Conversely, if you have the obligation to sell an underlying security at a fixed price and the security moves significantly below that fixed price then you could experience sizable losses. If you are writing options contracts and taking on an obligation to either buy or sell an underlying security at a fixed price, then you are exposed to similar risks. However, you can trade options purely by buying contracts and not writing them.

This means that you can limit your potential losses on each and every trade you make to the amount of money you invest in buying specific contracts. Whenever you buy options contracts, the worst case scenario is that they expire worthless and you lose your initial investment.

Even if you do want to write contracts in addition to buying them, you can easily create spreads to ensure that your losses are always limited. The potential for limited liabilities in options trading is a major advantage, particularly for those that are against high risk investments.

Another big advantage options trading offers is versatility. There are a number of strategies that you can use to create spreads that enable you to profit from multi-directional price movements. For example, you could create a spread that would result in profit if the underlying security went down in value a little bit, or if it stayed stable, or if it went up in value by any amount.

This would only result in limited losses if the underlying security went down a significant amount. With futures contracts, you can typically only make money from the underlying security moving in the right direction for you.

There could be unlimited losses if your investment moves in the wrong direction or if a neutral result occurs. Section Contents Quick Links. Advantages of Options Over Futures As mentioned above, when trading futures you are potentially exposed to big losses whichever side of the contract you are on.

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