What Are Exchange Traded Derivatives?
If you are beginning your investment journey or are connected with the financial markets, you could have, on multiple occasions, come across the term: derivative trading. You could have also read articles and reports either waxing eloquent about derivatives trading, or bashing it up, with a barrage of criticism. Well, the nature of the derivative market is such that it involves massive amounts of money, and it is no wonder that Warren Buffet called derivatives as weapons of mass destruction in financial markets.
Now you must understand the definition of derivative. They are essentially contracts, deriving values from the price fluctuations of their underlying assets. You can trade in various derivatives instruments, like stocks, currency, bonds, commodities etc. Here, you must understand that there are two types of derivatives; one that are subject to standardised terms and conditions, and hence being traded in the stock exchanges, and the second type being traded between private counter-parties, in the absence of a formal intermediary. While the first type is known as Exchange Traded Derivatives (ETDs), the second is known as Over the Counter (OTC) derivatives.
What Is ETD?
An Exchange Traded Derivative is standardised financial contract that is traded in stock exchanges in a regulated manner. They are subject to the rules framed by market regulators such as the Securities and Exchange Board of India (SEBI) in India or Securities and Exchange Commission in the USA. As compared to OTC derivatives, ETDs have certain advantages, like uniformity of rules and elimination of default risks.
Features Of Exchange Traded Derivatives
Now that you know what is ETD, here is a look at its defining features:
Standardised Contracts: In an exchange traded market, the financial contract is standardised. Every contract has a predetermined expiration date, uniformity in the volume being traded, and being subject to the rules and regulations as framed by the stock exchange.
Easy Offsetting Of Previous Contracts: While understanding Exchange Traded Derivatives meaning, you have to keep in mind that ETDs provide tremendous convenience to traders by having the provision of offsetting of previous contracts. Any ETD can be offset in the following ways:
- Traders can sell their current position in the market
- Traders can purchase an offset position at a revised price.
Presence Of An Intermediary: Unlike, OTC derivatives, Exchange Traded Derivatives don’t have direct counter-party risk. This is because the stock exchange contractually binds the trading parties, and acts as a formal intermediary to eliminate any risk of default.
Subject To Rules And Regulations: Any exchange traded market is subject to the rules and regulations of market regulators. It has to publish information, on a daily basis, about the major trades being executed. This prevents scenarios such as cornering of the market by few participants. The rules and regulations make it difficult for big players to circumvent the rules via short squeezes and other unfair trade practices.
Market Depth : To grasp the Exchange Traded Derivatives meaning, you must keep in mind that any exchange traded derivative market carries considerable market depth. In other words, these markets have high liquidity. This allows traders wanting to reverse their positions or selling their stakes to easily find counter-parties.
Types of Exchange Traded Derivatives
Now that you have grasped the Exchange Traded Derivatives meaning, let’s have a look at the different types of ETDs:
The first in the list of the types of Exchange Traded Derivatives is the stock segment. In India, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) deal exclusively in stock derivatives. The types of stock derivatives are:
- Stock Forwards
- Stock Options
Using both the types of stock derivatives, traders can take highly leveraged positions on the price movements of stocks. Here, you must remember that stock swaps are not allowed to be traded via stock exchanges, and these are a part of the OTC derivatives market.
These types of Exchange Traded Derivatives trade on the major stock indices. You can purchase or sell both index forwards and index options. However, unlike stock options where you can opt for settlement either in cash or via delivery of stocks, index options have to settle in cash. Some of the popular traded Index ETDs in India, and across the globe include:
- Nifty 50 The stock market index of the NSE, representing the weighted average of 50 of the largest companies listed on the stock exchange.
- Sensex The stock market index of the BSE, representing the free-floating, market weighted average of the 30 well-established companies listed on the exchange.
- Nikkei The stock market index of the Tokyo Stock Exchange, measuring the performance of the 225 largest, publicly listed companies in Japan.
- S&P 500 Among the stock market indices in the USA, it measures the stock performances of the 500 well-established companies, listed across stock exchanges in the USA.
Here, you have the option to trade as per the price movement of the currencies in the stock exchange. Unlike OTC derivatives trade in currency, ETDs in currencies allow for standardised contracts only across the specified pairs of currencies. For example, you can trade in the following pairs of currency-related ETDs in the NSE:
- Indian Rupee vs United States Dollar (INR-USD)
- Indian Rupee vs Euro (INR-EUR)
- Indian Rupee vs Great Britain Pound (INR-GBP)
- Indian Rupee vs Japan’s Yen (INR-JPY)
These types of Exchange Traded Derivatives are traded on the price fluctuations of scores of commodities. In India, you can trade in commodities futures at the Multi Commodity Exchange of India Ltd (MCX). Some of the examples of standardised contracts on commodities include gold, crude oil, silver, natural gas, copper, zinc etc.
These types of Exchange Traded Derivatives allow you to trade in bonds. For instance, the NSE has an exclusive platform to trade in bond derivatives products. You can use this platform to trade in interest rate futures. The NSE provides for two instruments in the segment for interest rate futures:
- NBF II - Futures on Govt. of India securities for 6,10 and 13 years
- 91DTB -Futures on Govt. of India treasury bill for 91 days.
Thus, an exchange traded derivative market can allow you to trade in various derivative products through a standardised financial contract. As the stock exchange itself acts as a counter-party, it allows to eliminate the default risk in the transactions. Now that you know what is ETD, you can add these to your investment portfolio. While investing in stock markets, do remember to select a trusted and reputed financial partner. Opt for a broking firm which provides multiple benefits, like free Demat account and trading account, All-in-1 trading platform, state-of-the-art technology, discounts on online trading, and so on.