In terms of share market basics, equity is the share of a particular company owned by an investor, which allows him/her to enjoy the same profits and successes that an owner of the company does.
Equity as assets
The shares you own, which are equity securities, can act as underlying assets that lend value to financial instruments called derivatives. Assets also include bonds, commodities, and securities, and their value is dependent on price movements of stocksin the Indian share market and profit earned by companies. The value of a share is measured through its share price.
A derivative is a security in the form of an agreement signed between two or more entities to buy or sell assets in the future. This agreement is called a contract. Investors make profits by anticipating the future value of that asset.
Benefits of derivatives
1. Risk management:
Investors trade equity derivatives in order to transfer or transform the risks associated with assets. This risk is shifted from risk-averse individuals to those who undertake heavy risks in the share market, thus allowing the former to enhance their safety.
2. Physical settlement:
Many investors, while retaining their shares for a long term, wish to reap the benefits of price fluctuations in the short term. This can be achieved through physical settlement, thereby allowing you to earn money on idle shares.
3. Protection against fluctuation:
The process of hedging involves investing in related securities to reduce the risk of an adverse change in prices of an asset. This will not only allow you to protect yourself from a fall in the prices of shares that you own but also act as a safeguard against the rising prices of shares that you wish to buy.
4. Arbitrage trading:
Arbitrage trading involves the simultaneous selling of an asset in one share market and buying in another to profit from the difference in price. In India, these two markets are the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). A profit is earned because the share has more value in one market and is cheaper in the other.
5. Margin trading:
While trading on a contract, you only pay a margin and not the entire amount, which could sometimes run into large amounts. This will allow you to maintain a high outstanding, and the profit earned from accurate predictions results in an exponentially high growth.
Types of derivative contracts
- Futures are contracts that state that an investor must buy or sell an asset at a specified time for a specific price. The nature of futures contracts are such that unlimited gains and losses result from trading activity.
- Options are different from futures such that there is no obligation on the part of the buyer to hold the terms of the agreement. The seller, on the other hand, is obliged to comply with the contract, that is, he must sell the shares. Trading in the Options market involves unlimited gains but limited losses.