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What are Exchange Traded Derivatives

22 Jun 2023

Introduction

If you are venturing into investments or navigating the financial markets, you have likely come across the term “Derivative Trading.” Since it is an effective profit-making tool, investors and traders allocate capital to derivatives, aiming for profitability in any market scenario. One of the derivatives that investors love to talk about is Exchange-Traded Derivatives.

In this blog, we will cover the detailed concept of Exchange-traded derivatives, including their meaning, types, and benefits. So, delve deep into it.

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What are Exchange-Traded Derivatives?

Exchange-Traded Derivatives are listed and traded on regulated exchanges. These financial contracts provide advantages on top of over-the-counter (OTC) derivatives. They also enable hedging and speculation of diverse assets, like commodities, currencies, equities, and interest rates in a regulated environment. 

What are the types of Exchange-Traded Derivatives?

Exchange-traded derivatives are of six different types. They are:

Stock ETDs

Exchange-traded derivatives commonly involve stocks as underlying assets. Traders use these derivatives to speculate on stock price movements. On the other hand, stock derivatives on exchanges like the Bombay Stock Exchange and National Stock Exchange influence future stock movements.

Index ETDs

Investors seeking exposure to an entire exchange can trade in stock index derivatives, representing a portfolio of stocks. Unlike stock derivatives, index derivatives do not have physical delivery. Popular index derivatives include Nifty 50, Sensex, Nasdaq, S&P 500, and Nikkei.

Currency ETDs

Currency exchange-traded derivatives enable trading based on currency price movements. Unlike OTC derivatives, currency ETDs involved standardized contracts specific to currency pairs. Examples of currency-related ETDs on the NSE are INR-USD, INR-EUR, INR-JYP, and INR-GBP.

Commodity ETDs

Commodity exchange-traded derivatives feature underlying assets such as gold, silver, copper, natural gas, and crude oil. Investing in them provides exposure to commodities without direct risks.

Bonds ETDs

Bond exchange-traded derivatives facilitate trading in bonds as underlying assets. The NSE offers a dedicated platform for bond derivatives, including interest rate futures like NBF II (6, 10, and 13 years) and 91DTB (91-day GOI treasury bill) futures.

Real-Estate ETDs

Real estate exchange-traded derivative contracts enable trading in the sector without physical ownership. With substantial trading volume, they offer a means to diversify portfolio risks and participate in the real estate market.

What are the features and advantages of Exchange-Traded Derivatives?

The features and advantages of exchange-traded derivatives are:

Standardization

Exchange-traded derivatives offer standardized terms, simplifying essential information for investors. Contracts specify contract value, security or item quantity (e.g. lots), and buying/selling limits. Small investors can opt for mini options (10 shares) on high-priced stocks for more manageable capital involvement.

Default Risk Elimination

Exchange-traded derivatives mitigate counterparty risk by designing the exchange as the buyer for sellers and the seller for buyers. Mark-to-market calculation ensures daily gain/loss assessment. In case of losses eroding margin, timely capital replenishment is necessary to avoid position liquidation.

Market Depth

Exchange-traded derivatives (ETDs) offer deep market liquidity, facilitating swift reversals and efficient connections with counterparties. High liquidity ensures quick trade execution and minimal losses, making it easy to find parties for transactions.

Rules and Regulations

The exchange-traded market adheres to regulations set by market authorities. Daily publication of major trades prevents manipulation and unfair practices like short squeezes, creating a level playing field for all participants.

Intermediary Presence

Exchange-traded derivatives eliminate counterparty risk as parties trade through an intermediary, the stock exchange. The exchange acts as a contractual intermediary, ensuring no risk of default between the parties involved.

Efficient Offsetting

Exchange-traded derivatives offer traders the convenience of offsetting previous contracts. This can be done by selling the current position in the market or purchasing an offset position at a revised price.

Conclusion

Exchange-traded derivatives are regulated, liquid assets, offering lower risk compared to over-the-counter trading. However, trading futures and options still carry substantial risk. When you gain a thorough understanding of these contracts, you can effectively hedge and speculate on asset prices in the market. It is also crucial to acknowledge the inherent risk while using derivatives for informed decision-making in the market.

Related Articles: 8 basic principles to follow while trading equities and derivatives | Why Different Derivative Contracts Have Different Lot Size | What are Currency Derivatives in India

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