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Non-Equity Option

Updated on April 15, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Non-Equity Option?

Non-equity options are a type of financial derivative that derive their value from an underlying index, such as a stock market index, based on broader market movements. These options allow investors and traders to hedge against and speculate on the overall market’s direction.

non equity options

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Non-equity options allow investors to profit from fluctuations in the index’s valuation without directly trading individual stocks in their portfolios. These options indirectly expose investors to the entire market or specific sectors without owning individual securities. Overall, they provide a valuable tool for investors and traders to navigate and participate in broader market movements. They offer flexibility, diversification, and potential opportunities for profit while managing risks associated with the overall market performance.

Key Takeaways

  • Non-equity options are financial derivatives that derive value from the performance of broader market indices, such as stock market indexes, reflecting wider market movements.
  • They provide investors and traders with exposure to the overall market.
  • Non-equity options serve as versatile financial assets, offering risk management tools for portfolio protection, speculation opportunities on various assets, hedging mechanisms to counter potential losses, and income generation through selling options.
  • Traders employ various strategies in non-equity options trading, including income generation through selling covered call options, hedging to protect against losses, and spread trading to capitalize on price relationships.

Non-Equity Option Explained

Non-equity options are derivative contracts that derive their value from underlying assets other than stocks, such as commodities, currencies, interest rates, or futures contracts. These options offer traders a range of opportunities, including speculation on price movements, risk management, income generation, and capitalizing on volatility.

Various strategies, such as directional trading, volatility trading, spread trading, hedging, and income generation, are commonly employed in non-equity options. Traders can take positions by buying or selling calls or put options based on their price expectations. However, it is crucial to be aware of the associated risks, as options trading can result in the complete loss of the investment.

Furthermore, non-equity options serve multiple purposes, from hedging existing portfolios to generating income by selling options and collecting premiums. They can also be utilized for speculative purposes and to leverage volatility.

Non-equity options have various advantages, including the ability to profit in both rising and falling markets, flexible trading strategies, and limited risk exposure. However, it is important to consider the complexities of options trading, the potential for losses, and the requirement for knowledge and experience to navigate the market effectively.

In essence, comprehending non-equity options and their implications empowers traders to make informed decisions and effectively utilize these instruments to achieve their investment and trading goals. In addition, by understanding the intricacies and potential risks involved, traders can maximize the benefits of non-equity options and enhance their overall trading strategies.

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Functions

Non-equity options serve as versatile financial assets, offering unique opportunities to investors and traders. They perform several functions, including:

  • Risk Management: Non-equity options serve as valuable risk management tools, allowing individuals and businesses to safeguard their portfolios from potential losses caused by price fluctuations in various assets. By purchasing options, investors can effectively mitigate risks and protect their investments.
  • Speculation: Non-equity options enable traders to speculate by predicting and capitalizing on future price movements of various assets, such as commodities, currencies, interest rates, and futures contracts. Traders aim to profit from favorable price changes in these assets by taking positions aligned with their market predictions.
  • Hedging: Non-equity options provide an effective hedging mechanism for market participants to counterbalance potential losses in their current positions. By taking opposite positions through options contracts, investors can mitigate their exposure to unfavorable market conditions and minimize potential risks.
  • Income Generation: Selling options present an opportunity to generate income by collecting premiums. Although traders who sell options take on risks, they can profit from the premiums received if the options expire worthlessly or decrease in value over time.
  • Volatility Trading: Non-equity options allow traders to benefit from market volatility fluctuations. As volatility directly impacts options prices, traders can strategically employ various strategies to capitalize on anticipated increases or decrease in volatility levels.

By effectively understanding and utilizing non-equity options’ functions, investors and traders can make informed decisions and optimize their investment strategies in the derivatives market.

Trading Strategies

Trading Strategies for non-equity options are as follows:

  • Long Call or Put: Investors can take a bullish stance by purchasing a call option or a bearish stance by buying a put option. These strategies allow traders to profit from upward or downward movements in the underlying asset’s price respectively. As per the diagram below, the long call has limited downside risk, only up to the premium paid to enter the contract. But it has a huge unlimited upside potential and profit-making opportunity. For long put, the same is the case with loss. The loss is limited upto the premium contributed. But here the gain is not totally unlimited because the price of the underlying may fall to zero.  

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  • Covered Call: Covered Call strategy involves owning the underlying asset while simultaneously selling call options against it. It generates income through the premiums from selling the options but limits potential upside gains. As per the graph below, a trader buys a stock at $100 but also sells a call on the same at a $105 strike price, bringing the level of breakeven for the long position to $95. Thus, if the price of the stock goes up above $105, the trader makes a profit of $1000 because of a gain of $5 per share and a $500 overall gain. But if the price of the underlying stock falls below $105 at expiry, then the option is worthless.

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  • Straddle: A straddle strategy involves purchasing both a call option and a put option with the same strike price and expiration date. It aims to profit from significant price fluctuations, regardless of the market’s direction. Below is a payoff diagram of a long straddle, where the trader benefits from both the upside and downside movement of the underlying stock. Here, both the options, the call, and the put, are bought, and the trader gains when there is a significant movement of the market either upwards or downwards. As per the diagram, if the trader wants to earn a profit, the market should move to a large extent; otherwise, the probability of making a profit is very low. However, the position will suffer a maximum loss at the level where the stock will trade at the exact long strike price. The breakeven points are clearly identified, which marks the loss limits and makes it easier for the trader to understand their risk and return levels.

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Examples

Examples of non-equity options:

  • Index Options: The S&P 500 index options allow investors to speculate on or hedge against the movement of the overall stock market. By buying call options, investors can profit from an upward trend, while buying put options protects against market downturns.
  • Commodity Options: Options on commodities like gold, crude oil, or agricultural products allow market participants to trade these underlying assets’ price movements without physically owning them.
  • Currency Options: Currency options offer traders the ability to profit from or protect against fluctuations in exchange rates. For example, a company engaged in international trade may use currency options to hedge against potential currency exchange rate risks.

Frequently Asked Questions (FAQs)

1. What are the risks associated with non-equity options?

It comes with certain risks that traders and investors should know. One significant risk is the potential for loss of the entire investment, as options have expiration dates and may expire worthless if the underlying asset’s price does not move favorably. There is also the risk of market volatility, as options are influenced by changes in the price of the underlying asset.

2. What is the difference between equity options and non-equity options?

The main difference between equity and non-equity options lies in the underlying asset. Equity options are based on individual stocks, representing ownership in specific companies. On the other hand, non-equity options derive their value from broader indices, commodities, currencies, or interest rates.

3. How are non-equity options priced?

They are priced using various factors, including the current price of the underlying asset, the strike price of the option contract, the time to expiration, interest rates, dividends (for equity index options), and implied volatility. The options market utilizes mathematical models, such as the Black-Scholes model, to estimate the fair value of non-equity options. These models consider the interplay of these factors to determine an option’s price.

This article has been a guide to what is Non-Equity Option. Here, we explain the topic in detail, including its examples, functions, and trading strategies. You may also find some useful articles here –

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