Exchange-traded derivatives: What they are and how to trade them

Exchange Traded Derivatives (ETDs) are financial instruments, representing agreements between two parties to buy or sell assets at a predetermined price in the future. They play a crucial role in financial markets by providing traders with opportunities to manage risk, speculate on price movements, and diversify their portfolios. 

In India, the exchange traded derivatives market size is significant, with equity derivatives dominating, comprising 99.6% of the Indian stock market volumes as of October 2023. Therefore, understanding ETDs is essential for anyone involved in financial markets, as they offer opportunities for diversification and risk management.

In this article, we’ll explore what ETDs are, their features, and various types in an easy-to-understand manner.

What are exchange traded derivatives?

Exchange Traded commodity Derivatives (ETDs) are financial instruments traded on organised exchanges, representing contracts between two parties to buy or sell an underlying asset at a predetermined price and date in the future. 

Unlike over-the-counter derivatives, which are customised contracts between private parties, ETDs are standardised contracts with terms set by the exchange. Common types of ETDs include futures contracts, options contracts, and exchange-traded funds (ETFs). 

These derivatives play a crucial role in financial markets, offering traders opportunities to hedge against risks, speculate on price movements, and diversify their portfolios. 

ETDs are characterised by transparency, liquidity, and accessibility due to their exchange-traded nature.

Features of exchange traded derivatives

Exchange traded derivatives possess several distinct features that make them unique and attractive to traders. Here are some key features:

1. Standardisation

Standardization in exchange traded derivatives means that these contracts have fixed, uniform terms that are the same for all participants. This includes details like contract size, expiration date, and how they’re settled. 

Think of it like buying a product from a store where each item is the same size, colour, and price. This makes trading ETDs easier because everyone knows exactly what they’re getting, which boosts market activity and ensures fairness for all traders.

2. Exchange-traded

ETDs are bought and sold on organised marketplaces called exchanges. These exchanges ensure fairness, transparency, and oversight. They provide a central platform where buyers and sellers can trade ETD contracts at publicly displayed prices. 

This setup makes trading straightforward and secure since all transactions are conducted through regulated exchanges. 

Moreover, the exchange-traded nature of ETDs means that traders can easily enter and exit positions, benefiting from the liquidity and efficiency of these markets.

3. Leverage

ETDs let you control more trading with less money, called leverage. This means you can make bigger gains but also bigger losses. 

For example, if you buy a contract with Rs. 100, you might control Rs. 1,000 worth of assets. If the asset’s value rises, you could make a lot of money compared to your initial trade. 

However, if the value drops, you could lose a significant amount too. Leverage in ETDs can magnify both profits and losses.

4. Counterparty risk mitigation

When you trade exchange traded derivatives, a clearinghouse steps in to guarantee that both parties fulfil their obligations. 

So, if one party fails to deliver on the contract, the clearinghouse ensures the trade still happens. This reduces the risk of default, making trading safer. 

Essentially, the clearinghouse acts like a trusted middleman, ensuring that both buyers and sellers honour their agreements. This system adds a layer of security, giving you peace of mind when trading ETDs.

5. Regulation

Regulation means that there are rules and guidelines set by authorities to make sure that trading in ETDs is fair and safe for everyone involved. 

These rules help prevent things like fraud and manipulation, protecting traders like you. They also ensure that markets operate smoothly and efficiently. 

So, when you trade ETDs, you can feel confident knowing that there are regulations in place to safeguard your interests and maintain market stability. When comparing exchange traded vs OTC derivatives, ETDs offer more safety of funds. 

Types of exchange traded derivatives

ETDs cover a wide range of financial instruments traded on organized exchanges. Some of the common types of exchange traded derivatives traded in India are:

1. Futures contracts

Futures contracts in India are like promises to buy or sell something at a set price on a future date. 

Let’s say you agree to buy a certain quantity of rice at a specified price three months from now. If the price of rice rises, you’ll still buy it at the lower agreed-upon price. 

But if the price falls, you’ve locked in a good deal. This helps manage risks and allows for speculation on price movements.

2. Options contracts

Options contracts offer you the choice, but not the obligation, to buy (call option) or sell (put option) assets like stocks or indices at a set price within a specific timeframe. 

With options, you can benefit from price movements without committing to buying or selling the underlying asset. 

This flexibility makes them popular for managing risk or speculating on future market movements according to your financial goals and market expectations.

2. Index futures and options

Index Futures and Options allow you to trade in the overall stock market movement without buying individual stocks. With Index Futures, you agree to buy or sell an index at a set price on a future date. 

Options give you the choice to buy (call) or sell (put) an index at a predetermined price before expiry. They’re great for broad market exposure and managing risk without directly trading stocks.

3. Commodity futures

These are the contracts where you agree to buy or sell commodities like gold, oil, or agricultural products at a set price on a future date. 

They’re handy for managing price risks: if you’re a farmer, you can secure a price for your crops in advance, shielding you from market fluctuations. Traders also use them to speculate on future price movements, aiming to profit from price changes.

4. Currency futures and options

Currency futures and options let you bet on or hedge against currency movements. Say you’re planning an overseas trip and worry about the rupee’s value changing. You could buy currency futures to lock in a favourable exchange rate. 

Or, if you’re a business dealing with international clients, currency options could protect you from unexpected currency swings. 

These derivatives are based on major currency pairs like USD/INR and offer a straightforward way to manage currency risks.

5. Bond futures

Bond futures let you hedge against interest rate fluctuations or speculate on bond prices. When you buy or sell these contracts, you’re essentially agreeing to purchase or sell a bond at a predetermined price on a future date. 

By trading bond futures, you can manage risks associated with changes in interest rates and potentially profit from anticipated shifts in bond prices, all on organised exchanges.

6. Interest rate options (IROs)

Interest Rate Options let you hedge against or speculate on interest rate changes. They’re contracts based on interest rate benchmarks like government bond yields.

With IROs, you have the right, but not the obligation, to buy or sell a bond futures contract at a predetermined price within a specified time frame. This flexibility helps you manage risks associated with interest rate fluctuations in the financial market.

Conclusion

Exchange traded derivatives (ETDs) offer valuable tools for managing risks and exploring trading opportunities in the financial world. 

By understanding their basics, you can make informed decisions and navigate the markets more confidently. Remember, ETDs come in various forms, like futures contracts and options, each serving different purposes. For a simplified understanding of financial concepts, stay tuned to StockGro! 

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