Trading equity derivatives: What are they and how do they work

  • By Carole Ann Furman

  • June 23, 2018
  • 1:17 am BST

CFD trading includes trading instruments called derivatives, which allow traders to take part in the pricing of an underlying security. This consists of shifting the risks involved in the underlying security to other traders. Learning the CFD trading tips of derivatives can be beneficial to your investments. The following five derivative contracts could be the key to your increased returns each year.

Contract for difference

A contract for difference (CFD) is one of the most popular trading instruments and uses the concept of an arrangement between buyer and seller whereby the seller will pay the buyer the spread between current value and the value at the time of the contract should the price change. If the spread is in the negative, the buyer will pay the seller the difference. This derivative allows investors to predict price changes without having to own underlying shares. The benefit of CFDs is that there is no expiration date and allows for a reflection of the underlying security prices. CFDs also allow a high degree of leverage and margins if portfolio values drop, but can present significant risks of loss should security prices change.

Index return swap

The derivative known as equity index return swap consists of an agreement between investors to set dates over a number of years where they will swap sets of cash flows. This method is useful when seeking a simple way to gain asset class exposure in an affordable way. Buying an index and picking up shares in each component allows investors to adjust as the index changes. This method also allows for capital gains and monthly payouts at a set interest rate, affording them tax benefits too.


By using options, investors can hedge risks or even make use of added risks for speculation. Call and put options allow for buying and selling at a fixed rate with an expiration date on the option. Options are traded on exchanges and provide transparency and liquidity. The volatility of the contract and the stock, the intrinsic value of the underlying security, and the time premium that decreases as the expiration date gets nearer all influence the pricing of options. Luckily, there are various option trading strategies that surround the risks of the method, especially for sellers.

Single stock futures

A single stock future (SSF) is a derivative that uses the method of 100 shares of one stock being delivered by a set expiration date. The market price of SSFs is determined by the underlying security price and the cost of interest. There is usually a 20% margin range which provides the investors with more leverage, as well as no obligations to day trading or the short sellers’ uptick rule. There are five major benefits of SSF trading:

  • A cheap method of buying stock
  • Protection against volatility and underlying asset price declines
  • Experience in different economic sectors
  • A budget-friendly hedge against open equity
  • The use of long and short pairs to get exposure in a practical market


Investors are given the opportunity to purchase specific stocks on a specific date, which can be exercised at a set price. The price is usually higher than the underlying stock but has a long exercise period before the expiration date. Warrants do pose liquidity risks because of the often low volumes of exchanges. There is also a time premium that falls away as the expiration date gets nearer, and if the underlying security price does not reach the exercise price by its expiration date, the warrant becomes worthless.

The benefits of trading in derivatives are plenty, although there is often risk involved. However, with the many trading strategies and principles of hedges, controlled spreads and leverage, this way of trading can engender much success.