What Are Exchange Traded Derivatives?
If you are beginning your investment journey or are connected with the financial markets, you must have heard about ‘Derivative Trading’. As it is considered an effective profit-making tool, investors and traders allocate a portion of their capital towards derivatives to ensure they are profitable in almost every market situation. The nature of the derivative market is such that it involves massive amounts of money, making extensive learning about the term a vital aspect of your successful investment journey.
If you are looking to invest in derivatives, you must first understand their basic definition and meaning.
What are Derivatives?
Derivatives are financial contracts that derive their values from the price fluctuations of their underlying assets such as stocks, currency, bonds, commodities etc. Essentially, there are two types of derivatives; one that is subject to standardised terms and conditions, hence, traded in the stock exchanges, and the second type that is 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 a standardised financial contract that is traded on stock exchanges in a regulated manner. They are subject to the rules drafted by market regulators such as the Securities and Exchange Board of India (SEBI). Compared to OTC derivatives, ETDs have certain advantages, like the uniformity of rules and eliminating default risks.
Features Of Exchange Traded Derivatives
Standardised Contracts: ETDs are standardised contracts that come with a predetermined expiration date, uniformity in the volume being traded. They are subject to the rules and regulations framed by the stock exchange and regulatory authority.
Easy Offsetting Of Previous Contracts:ETDs provide tremendous convenience to traders by providing the option of offsetting previous contracts. An 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 counterparty 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:The exchange-traded market is subject to the rules and regulations of market regulators. It has to publish information daily, about the major trades being executed. The rules and regulations make it difficult for big players to circumvent the rules via short squeezes and other unfair trade practices.
Market Depth: Exchange-traded derivative market carries considerable market depth by having high liquidity. This allows traders who want to reverse their positions or sell their stakes to find counter-parties easily.
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 Exchange Traded Derivatives are based on the stock segment in which the ETDs have stocks as the underlying asset. The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE)deal exclusively in stock derivatives in India. The types of stock derivatives are:
- Stock Forwards
- Stock Options
Using both 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, which are 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 50represents the weighted average of 50 of the largest companies listed on the stock exchange.
- Sensex represents the free-floating, market-weighted average of the 30 well-established companies listed on the exchange.
- Nikkei is the stock market index of the Tokyo Stock Exchange, measuring the performance of the 225 largest publicly listed companies in Japan.
- S&P 500 is a stock market index in the USA that measures the stock performances of the 500 well-established companies listed across stock exchanges in the USA.
Currency ETDs allow you to trade as per the price movement of the currencies in the financial market. Unlike OTC derivatives that trade in various currencies at the same time, 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 have commodities as the underlying asset and are traded on the price fluctuations 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.
Bond ETDs allow you to trade in bonds. For instance, the NSE has an exclusive platform to trade in bond derivatives products that you can use to trade in derivatives with bonds as the underlying asset. The NSE provides for two instruments in the segment for Bond ETDs such as 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.
Exchange-traded derivatives trading can allow you to trade in various derivative products through a standardised financial contract. As the stock exchange itself acts as a counterparty, it significantly mitigates the default risk in the transactions. Now that you know what is ETD, you can add these to your investment portfolio and start making profits. Before investing in derivatives, do remember to select a trusted and reputed financial advisor. Opt for a broking firm that provides multiple benefits, like a free Demat account and trading account, an all-in-1 trading platform etc. like IIFL.