Equity Derivative.
What is an 'Equity Derivative'
An equity derivative is a derivative instrument with underlying assets based on equity securities. An equity derivative's value will fluctuate with changes in its underlying asset's equity, which is usually measured by share price. Investors can use equity derivatives to hedge the risk associated with taking a position in stock by setting limits to the losses incurred by either a short or long position in a company's shares.
BREAKING DOWN 'Equity Derivative'
Using Equity Options.
Equity options are derived from a single equity security. Investors and traders can use equity options to take a long or short position in a stock without actually buying or shorting the stock. This is advantageous because taking a position with options allows the investor/trader more leverage in that the amount of capital needed is much less than a similar outright long or short position on margin. Investors/traders can therefore profit more from a price movement in the underlying stock. There is however, a risk associated with using options to assume a position in a stock. If the underlying stock trades in the wrong direction and the options are out of the money at the time of their expiration, they become absolutely worthless and all the capital used to assume the position is lost.
Another popular equity options technique is trading option spreads. Traders take combinations of long and short positions of different options for the same underlying stock, with different strike prices and expiration dates, for the purpose of extracting profit from the option premiums with minimal risk.
Equity Index Futures.
A futures contract is similar to an option in that its value is derived from an underlying security, or in the case of an index futures contract, a group of securities that make up an index. For example, the S&P 500, the Dow index, and the Nasdaq index all have futures contracts available that are priced based on the value of the indexes. However, the values of the indexes are derived from the aggregate values all the underlying stocks in the index. Therefore, index futures ultimately derive their value from equities, hence the name equity index futures. These futures contracts are very liquid and are very versatile and useful financial tools. They can be used for everything from intraday trading to hedging risk for large diversified portfolios.

Options Defined.
Options are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.
Options are derivatives, which means their value is derived from the value of an underlying investment. Most frequently the underlying investment on which an option is based is the equity shares in a publicly listed company. Other underlying investments on which options can be based include stock indexes, Exchange Traded Funds (ETFs), government securities, foreign currencies or commodities like agricultural or industrial products. Stock options contracts are for 100 shares of the underlying stock - an exception would be when there are adjustments for stock splits or mergers.
Options are traded on securities marketplaces among institutional investors, individual investors, and professional traders and trades can be for one contract or for many. Fractional contracts are not traded.
An option contract is defined by the following elements: type (Put or Call), underlying security, unit of trade (number of shares), strike price and expiration date.
Options Symbology.
All option contracts that are of the same type and style and cover the same underlying security are referred to as a class of options. All options of the same class that also have the same unit of trade at the same strike price and expiration date are referred to as an option series.
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Chapter 2.5: What is Options Trading?
What are Options?
An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date. Options are a type of derivative product.
The right to sell a security is called a ‘Put Option’, while the right to buy is called the ‘Call Option’.
Leverage: Options help you profit from changes in share prices without putting down the full price of the share. You get control over the shares without buying them outright. Hedging : They can also be used to protect yourself from fluctuations in the price of a share and letting you buy or sell the shares at a pre-determined price for a specified period of time.
Though they have their advantages, trading in options is more complex than trading in regular shares. It calls for a good understanding of trading and investment practices as well as constant monitoring of market fluctuations to protect against losses.
About Options.
Just as futures contracts minimize risks for buyers by setting a pre-determined future price for an underlying asset, options contracts do the same however, without the obligation to buy that exists in a futures contract.
The seller of an options contract is called the ‘options writer’. Unlike the buyer in an options contract, the seller has no rights and must sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date, in exchange for an upfront payment from the buyer.
There is no physical exchange of documents at the time of entering into an options contract. The transactions are merely recorded in the stock exchange through which they are routed.
About Options.
When you are trading in the derivatives segment, you will come across many terms that may seem alien. Here are some Options-related jargons you should know about.
Premium: The upfront payment made by the buyer to the seller to enjoy the privileges of an option contract. Strike Price / Exercise Price: The pre-decided price at which the asset can be bought or sold.
Strike Price Intervals: These are the different strike prices at which an options contract can be traded. These are determined by the exchange on which the assets are traded.
There are typically at least 11 strike prices declared for every type of option in a given month - 5 prices above the spot price, 5prices below the spot price and one price equivalent to the spot price.
Following strike parameter is currently applicable for options contracts on all individual securities in NSE Derivative segment:
The strike price interval would be:
At the money - Out of the money.
may be enabled intraday in.
Strike Price Intervals for Nifty Index.
The number of contracts provided in options on index is based on the range in previous day’s closing value of the underlying index and applicable as per the following table:
Expiration Date:
A future date on or before which the options contract can be executed. Options contracts have three different durations you can pick from:
Near month (1 month) Middle Month (2 months) Far Month (3 months)
*Please note that long terms options are available for Nifty index. Futures & Options contracts typically expire on the last Thursday of the respective months, post which they are considered void.
American and European Options:
Please note that in Indian market only European type of options are available for trading.
E. g. options contracts for Reliance Industries have a lot size of 250 shares per contract.
Let us understand with an example:
If trader A buys 100 Nifty options from trader B where, both traders A and B are entering the market for the first time, the open interest would be 100 futures or two contract.
The next day, Trader A sells her contract to Trader C. This does not change the open interest, as a reduction in A’s open position is offset by an increase in C’s open position for this particular asset.
Now, if trader A buys 100 more Nifty Futures from another trader D, the open interest in the Nifty Futures contract would become 200 futures or 4contracts.
Types of Options.
As described earlier, options are of two types, the ‘Call Option’ and the ‘Put Option’.
Similarly, if the price of the stock rises during the contract period, the seller only loses the premium amount and does not suffer a loss of the entire price of the asset. Put options are abbreviated as ‘P’ in online quotes.
Understanding Options contracts with examples:
This means, under this contract, Rajesh has the rights to buy one lot of 100 Infosys shares at Rs 3000 per share any time between now and the month of May. He paid a premium of Rs 250 per share. He thus pays a total amount of Rs 25,000 to enjoy this right to sell.
Now, suppose the share price of Infosys rises over Rs 3,000 to Rs 3200, Rajesh can consider exercising the option and buying at Rs 3,000 per share. He would be saving Rs 200 per share; this can be considered a tentative profit. However, he still makes a notional net loss of Rs 50 per share once you take the premium amount into consideration. For this reason, Rajesh may choose to actually exercise the option once the share price crosses Rs 3,250 levels. Otherwise, he can choose to let the option expire without being exercised.
Rajesh believes that the shares of Company X are currently overpriced and bets on them falling in the next few months. Since he wants to secure his position, he takes a put option on the shares of Company X.
Here are the quotes for Stock X:
Rajesh buys 1000 shares of Company X Put at a strike price of 1070 and pays.
Rs 30 per share as premium. His total premium paid is Rs 30,000.
If the spot price for Company X falls below the Put option Rajesh bought, say to Rs 1020; Rajesh can safeguard his money by choosing to sell the put option. He will make Rs 50 per share (Rs 1070 minus Rs 1020) on the trade, making a net profit of Rs 20,000 (Rs 50 x 1000 shares – Rs 30,000 paid as premium).
Alternately, if the spot price for Company X rises higher than the Put option, say Rs 1080; he would be at a loss if he decided to exercise the put option at Rs 1070. So, he will choose, in this case, to not exercise the put option. In the process, he only loses Rs 30,000 – the premium amount; this is much lower than if he had exercised his option.
How are Options contracts priced?
We saw that options can be bought for an underlying asset at a fraction of the actual price of the asset in the spot market by paying an upfront premium. The amount paid as a premium to the seller is the price of entering an options contract.
To understand how this premium amount is arrived at, we first need to understand some basic terms like In-The-Money, Out-Of-The-Money and At-The-Money.
Let’s take a look as you may be faced with any one of these scenarios while trading in options:
In-the-money: You will profit by exercising the option. Out-of-the-money: You will make no money by exercising the option. At-the-money: A no-profit, no-loss scenario if you choose to exercise the option.
A Call Option is ‘In-the-money’ when the spot price of the asset is higher than the strike price. Conversely, a Put Option is ‘In-the-money’ when the spot price of the asset is lower than the strike price.
How is Premium Pricing arrived at :
The price of an Option Premium is controlled by two factors – intrinsic value and time value of the option.
Intrinsic Value is the difference between the cash market spot price and the strike price of an option. It can either be positive (if you are in-the-money) or zero (if you are either at-the-money or out-of-the-money). An asset cannot have negative Intrinsic Value. Time Value basically puts a premium on the time left to exercise an options contract. This means if the time left between the current date and the expiration date of Contract A is longer than that of Contract B, Contract A has higher Time Value.
This is because contracts with longer expiration periods give the holder more flexibility on when to exercise their option. This longer time window lowers the risk for the contract holder and prevents them from landing in a tight spot.
At the beginning of a contract period, the time value of the contract is high. If the option remains in-the-money, the option price for it will be high. If the option goes out-of-money or stays at-the-money this affects its intrinsic value, which becomes zero. In such a case, only the time value of the contract is considered and the option price goes down.
As the expiration date of the contract approaches, the time value of the contract falls, negatively affecting the option price.
In this section, we understood the basics of Options contracts. In the next part, we go into details about Call options and Put options. Click here.
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What is Equities Trading?
The term equity trading and stock trading are sometimes used synonymously; however, there are a few minor differences between the two. Let’s start with the basic definition; equity trading is essentially the purchase or sale of company stock through one of the major stock exchanges, just as stock trading is. An equity trade can be placed by the owner of the shares, through a brokerage account, or through an agent or broker; again, similar to stock trading.
The key difference between equity trading and stock trading lies in their investment options and management firms. Equity trading firms specialize in offering in-depth market research, trading expertise, unique trading systems (even algorithmic), and have direct access to the trading floor for better executions. These equities trading firms predominately exist in the form of hedge funds and are setup to trade within a larger investment bank; such as, Morgan Stanley, Goldman, Sachs, JPMorgan, and Bank of America to name a few.
Hedge Funds.
Hedge funds have more leeway in their investing activities and are generally far more active than traditional mutual funds that believe in the long term buy and hold approach; however, this tends to be a double edged sword. There have been many instances where hedge funds have significantly outperformed mutual funds and actually profited handsomely during down markets. Conversely, they take risks and these risks can wipe a large portion of your capital out if the hedge fund manager goes through a dry spell.
Hedge funds allow a fund manager with the flexibility to invest in any type of asset class that they choose, as long as it fits within their trading strategy or plan; this can include stock trading, equity trading, bond trading, equity option trading , or even foreign currency trading.
Private Equity Trading Firms.
There has been a flood of private equity day trading firms which have come to market, also known as “prop” firms. These companies grow their capital by allowing successful traders to have access to the firm’s capital. In many cases, these equities trading firms will design their own formula for success and require each trader to use this formula. Others will allow their traders to have free reign to use any strategy that they choose as long as they consistently remain profitable. For the most part, private equity day trading firms utilize technical analysis and their ability to track money flow to take advantage of short term trading opportunities in the markets.
Where Can I Trade Equities?
In the past, equity traders conducted business in-person. Back in the day, you as an investor would call your order in to your brokerage firm, at which point the order would flow down to the trading floor. We all remember seeing pictures of men yelling at each other to fill orders while holding small sheets of papers in their hands. There were huge blackboards with people sliding up and down the ladder updating prices with chalk.
Well, needless to say, we have progressed quite a bit from chalkboards.
Today, trading is automated and completely electronic. Many stock exchanges no longer have pits and use supercomputing to fill orders. Traders are able to purchase stocks remotely using their computer or smart phone. This happens through easy-to-use trading platforms, where equity traders have access to real-life charts and market execution capabilities such as trade tickets.
Now, you can buy or sell stocks with a simple click of the mouse or push of a finger using your tablet. The only thing stopping you from placing a trade is opening an online brokerage account.
Oh how things have changed!
Now that we have covered equities trading, let's dig into stock trading, which is were the common person will likely conduct their trading activity.
Stock Trading.
If you think that you will start making money in a flash after opening a trading account, you are absolutely wrong. Stock trading is all about having the odds on your side. When trading, 100% success is a fairytale.
In order to be successful at stock trading, you must be detailed oriented and have a methodical system for interpreting market behavior.
If your analysis is sound and you are a disciplined trader, you just might have a shot at this the greatest of all games.
Now, I would like to introduce you to the two types of analysis every stock trader should be aware of prior to investing one dime in the market.
Fundamental Analysis.
Fundamental analysis covers all of the financial aspects of a company which are made available to the public in the form of quarterly reports and annual statements.
Additional information sources include the quality of the executive management team, news events and overall economic data which could impact the company’s performance.
In other words, you should be aware of micro and macro events that could impact the company’s bottom line.
I will give you an example with a Bulgarian bank. Its clients were falsely informed that the bank is performing poorly and that the company is on the brink of bankruptcy. As a result of this misinformation, there were numerous deposit withdrawals from that bank. This led to lack of operative capital and the bears were then able to run the stock price down.
The inability to secure financing due to the perceived market risk ultimately led to the bank filing for bankruptcy.
News can be a powerful market driver; therefore, you should always be abreast of what’s going on if you decide to use fundamental analysis as your method for interpreting market performance.
Technical Analysis.
Let me be clear, technical analysis is my preferred method for making invest decisions – point blank.
Technical analysis of a security involves a detailed examination of the stock price on a chart. If you have read some of our previous materials you know that price moves represent not what traders think, but what they are willing to pay.
If there are more buyers than sellers, then the price will increase. If there are more people looking to exit a trade, price will fall like a rock.
Below are just a few items technical analysis provides:
1. Support and Resistance.
The areas where buyers are willing to step in are called support. The areas where sellers are looking to exit or add to short positions are called resistance.
2. Trend Lines.
When price increases, we can very often follow the move with a straight line. This line is called a trend line. When the trend line is inclined, we have a bullish trend. When the trend line is declining, we have a bearish trend line.
Trend lines are a great method for adding to existing positions that are going in the direction of the primary trend.
Above is an example of a bearish trend line. Notice how the line is tested a total of 9 times as the stock continues lower.
For the most part you want to trade in the direction of the primary trend, especially if you are somewhat new to trading – remember the trend is your friend!
3. Indicators.
Technical indicators are used to gauge the price action in a repeatable fashion. This way you can use these indicators to confirm market conditions such as overbought and oversold conditions.
There are two types of equity trading indicators:
Leading Indicators: These are the tools, which give us a trading signal before the event actually occurs.
Benefit – early entry in trades.
Negative – many fake signals.
Lagging Indicators: These are the tools, which give you a confirmation signal after the event has already started.
Negative – later entry in trades.
Benefit – relatively less fake signals.
Top Lagging Indicators: Moving Average, MACD.
Building Your Stock Trading Strategy.
Since you are now familiar with the two types of stock analysis, you next need to develop your trading strategy. I will give you a few equity trading tips, which will help you to find your place in the markets.
1. Build a portfolio.
You simply cannot follow all the stocks in the market. If you are a newbie, I will advise you to pick five stocks from the same sector, so you will also get familiar with their industry. This way you will concentrate on one place instead of blindly trading every market.
2. Make a list of events.
When the markets close on Friday you have a whole weekend to prepare for the upcoming week. List the upcoming news events for your five stocks. This way, you will know what to expect from the securities you trade and what events could impact your positions.
3. Plan your money management.
Most brokerage firms will throw money at you in the form of leverage, but please resist the urge.
As a beginner, try not to risk more than 1% of your total cash on any trade. This means that with $10,000 you should maximum risk $100 per trade.
You should decide how much of your buying power to invest in each of your trades. I believe that for a beginner trader, 10% of your buying power is an optimal investment. However, remember to exit your losing trades with a maximum 1% loss of your cash.
4. Pick two trading indicators.
Test a number of indicators to figure how which one suits your trading needs the best. You will want to pick indicators that help validate signals, but serve different functions. For example, you may want to use an oscillator with an on-chart indicator to confirm the price action.
If you were to use two oscillators, they will both say the same thing, just in different ways.
5. Always use a stop loss order>/h4>
Trading platforms let you chose specific levels where you will exit losing trades. This feature is called a stop loss. We discussed that with a $10,000 account value, you should not risk more than $100 per trade (1%).
Although you are protected with a stop, don’t always let your stop trigger. Remember, the goal is to walk away with money in your pocket. If you see the price moving against you, simply exit the trade with a small loss. The 1% stop is for protection against a very rapid and volatile price moves, not an entitlement program for other traders.
How to Back Test a Trading Strategy.
Today you can actually test your strategy without risking any money!
You simply need a trading platform that replays real market data for you to test drive all of the items we have outlined in this article.
The best platform for testing your strategy is Tradingsim!
Have a look at the image below:
This is a screenshot of the Tradingsim platform with an Apple Inc. chart. I have included two indicators which are the MACD and the 20-period simple moving average (blue line).
In the red rectangles, you see the variety of tools the platform offers. You have a host of drawing tools, including Fibonacci levels and harmonic patterns. Also, you have a huge set of trading tools at your disposal.
The right sidebar on the image is the order panel.
Simply enter the “quantity” for the number of shares you want to trade. You can then “buy” or “short” the stock. It’s literally that simple! You can also adjust your account balance for all of you out there that want to see what it feels like to trade with a million dollars.
The blue rectangle shows the chart control panel. The playback controls are very similar to what you might see in YouTube or your home DVR. This allows you to take your back testing to a more granular level not present in other trading platforms.
The chart above shows a successful long trade. We have the price breaking the 20-period SMA and a bullish MACD crossover. Notice how you can see the number of shares purchased and the total gain make on the position.
You my friend can place hundreds or thousands of trades just like this in order to hone your skills prior to investing in the market.
Conclusion.
All in all, we can say that equity trading can be viewed as a niche within the general stock trading arena. It is geared for more aggressive individuals, money managers and investors, who have either developed solid trading strategies or want to invest in them. These strategies are usually very intricate in design and one should do their due diligence before they consider investing in them. There are usually very heavy minimum investment amounts and heavy profit sharing models which can take up to 40% of your profits. While it can be risky and seem expensive, the rewards can also be commensurate if you find the right money manager.