Differences Between Equity and Derivatives
- 4m0•
- 27 Sep 2023
Understanding the distinctions between various investment options is crucial for making informed decisions. Two commonly used terms in the realm of investments are equity and derivatives. Read on to learn the differences between equity and derivatives and other aspects.
What is Equity?
Equity, often referred to as stocks or shares, represents ownership in a company. When you invest in equity, you become a shareholder and hold a stake in the company's assets and profits. Some critical aspects of equity are as follows:
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Ownership: When you buy equity in a company, you become a partial owner. Your returns are linked to the company's performance, including profits and losses.
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Risk and Reward: Equity investments come with both the potential for high returns and higher levels of risk. Stock prices can fluctuate due to market conditions and company performance.
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Dividends: Equity investors may receive dividends, a portion of the company's profits distributed to shareholders. These payments can provide a steady income stream.
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Voting Rights: Depending on the type of equity you hold, you may have the right to vote on specific company issues, such as the election of the board of directors.
What are Derivatives?
Derivatives, on the other hand, are financial contracts whose value is derived from an underlying asset. You can use these contracts for hedging, speculation, or arbitrage. Let's explore the key characteristics of derivatives:
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No Ownership: Unlike equity, derivatives do not grant ownership in the underlying asset. Instead, they provide a way to speculate on price movements without owning the asset itself.
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Leverage: Derivatives often allow traders to use leverage, which means you can control a larger position with a relatively small amount of capital. While this can amplify profits, it also increases the potential for losses.
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Types of Derivatives: Various derivatives exist, including options and futures. With options, you have the right but not any obligation to purchase or sell an asset at a prespecific price.
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Risk Profile: Derivatives are known for their complexity and can carry substantial risks. They warrant a thorough understanding of the market and the instruments themselves.
Differences Between Equity and Derivatives
Here are the key differences between equity and derivatives on various aspects:
Ownership
Represents ownership in a company
Don’t grant ownership rights
Purpose
Typically held for the long-term
Used for short-term speculation, hedging or arbitrage
Risks
Though subject to market risks, it is comparatively less than derivatives
Involves higher level of risk due to complexity and leverage
Income
May provide income through dividends
Don’t provide income through dividends
Voting rights
Shareholders enjoy voting rights on company matters
Don’t typically have voting rights
Holding duration
Held for the long term
Held for short or medium terms
Profit Timing
Profits realized when the asset's price exceeds the strike price.
Profits realized when the asset's price falls below the strike price.
| Aspect | Equity | Derivatives |
|---|---|---|
| Ownership | Represents ownership in a company | Don’t grant ownership rights |
| Purpose | Typically held for the long-term | Used for short-term speculation, hedging or arbitrage |
| Risks | Though subject to market risks, it is comparatively less than derivatives | Involves higher level of risk due to complexity and leverage |
| Income | May provide income through dividends | Don’t provide income through dividends |
| Voting rights | Shareholders enjoy voting rights on company matters | Don’t typically have voting rights |
| Holding duration | Held for the long term | Held for short or medium terms |
| Profit Timing | Profits realized when the asset's price exceeds the strike price. | Profits realized when the asset's price falls below the strike price. |
Equity vs Derivatives - What to Choose?
Go for equities if you:
- Seek long-term ownership and potential dividend income from a company.
- Are comfortable with market volatility and are willing to hold investments for an extended period.
- Want voting rights in the company's decision-making processes.
- Prefer straightforward investment instruments without complex financial contracts.
On the other hand, go for derivatives if you:
- Are experienced in financial markets and understand the complexities of derivative instruments.
- Want to speculate on short-term price fluctuation or hedge against specific risks.
- Are comfortable with leverage and the potential for amplified gains or losses.
- Have a specific trading strategy that involves options, futures, or other derivative contracts.
Your choice between the two should align with your goals, risk appetite, and understanding of these financial instruments.
FAQs on Differences Between Equity and Derivatives
Your ownership in shares is commonly referred to as equity securities. Conversely, a derivative represents a contractual agreement entered into by two or more parties to engage in the buying or selling of assets at a future date. Investors realize profits by predicting or assessing the prospective value of these assets.
Since derivatives derive value from underlying assets, seasoned traders often utilize them for risk mitigation through buying and selling. Conversely, for novice investors, derivatives can have a contrary impact, significantly elevating the risk profile of their investment portfolios.
Exercise settlement involves the cash settlement process, which is carried out by either debiting or crediting the clearing accounts of the pertinent Clearing Members with the corresponding Clearing Bank.
