The financial market has various segments where different types of securities are traded on exchanges or in over-the-counter (OTC) markets. Two segments that are now vying for the attention of retail participants in India are the equity market and the derivatives market. The choice between equity and derivatives trading is not always easy.
Many beginners are enticed by the promise of quick potential profits in the derivatives segment and engage in F&O trading without any awareness. If you are not sure about the choice of equity vs derivatives, this article can help you understand the key differences between equity and derivatives.
What is the meaning of equity?
Equity, also commonly known as stocks or shares, represents a unit of ownership in a company. In the equity market, companies issue their shares to the public for the first time via an Initial Public Offering (IPO). Once the IPO closes, the company’s shares are listed on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) and traded in the secondary market.
Some of the key features of equity stocks include the following:
- Ownership in the issuing company: Each equity stock represents 1 unit of ownership in the company. So, for instance, if a company has 1 lakh outstanding shares and you own 1,000 shares in the company, it means you own 1% of the entity.
- Risk-reward ratio: The risk-reward proposition for equity stocks is generally skewed in favour of the risk. However, over the long term, many equity stocks have historically delivered benchmark-beating returns. Nevertheless, the returns are not guaranteed.
- Voting rights: Equity shares give shareholders the right to vote in the company’s Annual General Meetings (AGMs) on matters concerning its future and policies. This benefit is particularly useful for long-term investors who want a say in the company’s growth.
- Dividend payouts: Some companies may pay a part of their profits to eligible shareholders in the form of dividends. For instance, if you hold 100 shares in a company that declares dividends at Rs. 10 per share, you will earn Rs. 1,000 as a dividend.
What are derivatives?
Derivatives are vastly different equity stocks. They are contracts that derive their value from an underlying asset — which could be an equity stock, a currency pair or a commodity. This leads to different types of securities like equity derivatives, commodity derivatives and currency derivatives.
Derivatives can also be classified as futures and options based on the terms of the contract. Let us see how this works.
- Futures: In a futures contract, two parties decide to purchase and sell the underlying asset at a specific price on a specific date in the future. This contract must be executed by both parties, and neither party has the right to let the contract expire.
- Options: An options contract also derives its value from an underlying asset. It gives the holder (or the buyer) of the options contract the right to purchase or sell the underlying asset at a fixed price on or before a specific date. The options buyer is not obligated to carry out the terms. Options contracts can be any one of two types — namely, call options that offer the right to buy the asset and put options that offer the right to sell the asset.
The differences between equity and derivatives
Now that you know the fundamentals of equity and derivatives, let us see how they stack up against one another. The table below shows you the key differences between equity and derivatives.
| Particulars | Equity | Derivatives |
| Meaning | A security that represents ownership in a company and a share of its assets and earnings | Financial contracts that derive their value from an underlying asset or index |
| Risk | Generally considered less risky compared to derivatives as the risk is mainly limited to the decrease in stock value | Can be highly risky, depending on the type of derivative and leverage used |
| Potential returns | Returns are primarily earned through possible capital appreciation and dividends | Returns are based on changes in the underlying asset's price, so derivatives can offer potentially high returns due to leverage |
| Holding period or investment tenure | Can be traded over the short term or held as long-term investments | Often used for short-term trading, hedging or speculation as they carry specific expiration dates |
| Complexity | Relatively straightforward, with their value directly tied to the company’s performance and market sentiment | Can be complex as the value depends on various factors like the underlying asset, contract terms, expiry and leverage |
| Leverage | Generally, no inherent leverage, but investors may take on leverage separately | Often involve leverage, meaning a small movement in the underlying asset can lead to significant gains or losses |
Equity vs derivatives: Which segment should you be trading in?
The choice between equity and derivatives depends on various factors like your trading or investment goals, risk tolerance and capacity, level of expertise and market knowledge. If you are a beginner to the financial markets or if you have a low tolerance for market risk but still want to earn market-linked returns, the equity market may be suitable. However, if you are a seasoned trader with a clear understanding of the F&O market and have a high tolerance for risk, you may also consider trading in the derivatives market.
