If you have ever tried to understand any financial markets or watched 5 mins of financial news regularly or read a financial newspaper every once in a while, chances are you have heard the word derivatives several times, and the word exchanged traded derivatives will cross your mind as soon as you read it here.
The media and finance enthusiasts are full of positive and negative views about derivatives. The mind-boggling numbers behind these contracts can make anyone intrigued about the nature of these contracts and their functioning. Derivative contracts derive their value from the price fluctuation of the underlying assets. Derivatives can be derived from anything such as stocks, commodities, real estate, currencies, indices, etc. Exchange Traded Derivatives that involve a standardized contract with fixed terms and conditions and over-the-counter derivatives which involve private trading between counterparties are the two types of derivatives.
Here we focus on understanding the Exchange Traded Derivatives, their functionality, various advantages, disadvantages, and the types of Exchange Traded Derivatives.
What are Exchange Traded Derivatives?
It is a standardized financial contract traded in the stock market in regulated conduct. The value of the contract is determined from the underlying assets under fixed regulations. In India, the rules and regulations for trading such Exchange Traded Derivatives are formed by the Securities Exchange Board of India (SEBI). The Exchange Traded Derivatives comprise mainly the futures and options traded on the public exchanges and are well suited for retail investors.
Features of Exchange Traded Derivatives
The Exchange Traded Derivatives are becoming increasingly popular due to the benefits such as:
The major differentiating factor of ETD is standardized contracts. Every Exchange traded derivative contract has a predetermined expiration date, lot size, settlement process, and other rules and regulations issued by the stock exchange. This eliminates the difficulty of buyers and sellers wanting specialized contracts, making it easy for the Exchange.
- Reduced Risk of Default due to Intermediation
In ETDs, the parties are not dealing with each other but rather through an intermediary. This eliminates the counterparty risk. The Exchange, which is the intermediary, is a credible counterparty. This highly reduces the chances of default as both the parties are contractually bound to the intermediary.
- Highly liquid
Market depth is a core feature of Exchange Traded Derivatives, i.e., the markets have high liquidity. This enables easy reversal of positions of traders as it does not take much time to connect with a counterparty to make an opposite bet against or sell their stake. The liquid market allows such parties to be found and traded quickly, leading to the stake being sold without any significant loss.
- Easy Offsetting
Exchange Traded Derivatives can be bought from the market with much ease due to the traders having the option of offsetting any previous contracts. An ETD can be settled without much hassle in two ways: selling its current position out in the market and purchasing an offset position at a revised price.
- Regulated Exchange
Exchanged traded derivatives are safer in nature since the Exchange is an unbiased body with many regulations. It also saves the big parties from cornering the market, never leading to complete control over the commodity only with a few participants.
Types of Exchange Traded Derivatives
Now that we have seen Exchange Traded Derivatives in detail, let’s venture into understanding the different kinds of Exchange Traded Derivatives.
- Stock ETDs
In Exchange Traded Derivatives, common stock is most commonly traded. They are further available in different types, such as stock options and stock forwards. Highly levered positions on price movements can be taken using these stocks. The stock derivatives in India are dealt exclusively by the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). However, stock derivatives are considered as the prime derivatives used to direct the future movement of stocks.
- Index ETDs
Some investors would like to buy or sell an entire exchange rather than just futures of a few particular stocks. The Exchange is a portfolio of the stocks that are considered under it, so it forms a group of stock-related derivatives. Investors trade on significant stock indices.
The primary difference between stock and index indices is that the physical delivery of stock derivatives is possible. For example, one can demand one stock derivative of TCS, and it can be paid in cash or kind. However, one cannot demand one stock index of BSE. There is no physical delivery in index derivatives.
- Commodities ETDs
Commodities here usually refer to raw materials. Standardized contracts include physical assets and commodities such as gold, silver, crude oil, zinc, etc., used as underlying assets for futures and options. Commodity derivatives trading in India can be done at Multi Commodity Exchange of India Ltd (MCX).
- Currency ETDs
Exchange Traded Derivatives related to currencies are also listed for trading. The ETD markets provide regulated contracts as compared to the OTC markets that provide many negotiation options. Investors can go long and short on the futures and options contracts available on only a few currency pairs. For example, an investor can trade on only four pairs of currency ETD that are offered by the National Stock Exchange (NSE):
– Indian Rupee vs. Euro
– Indian Rupee vs. USD
– Indian Rupee vs. Great Britain pound
– Indian Rupee vs. Japanese Yen
- Real Estate ETDs
Exchange Traded Derivatives allow the investors to invest in real estate without owning any buildings or corporate spaces. They were at the centre of the 2008 Global financial crisis. The real estate ETDs have been widely traded in the past, and despite the reduced popularity, they are still traded in good volumes. They are complex and structured instruments that need to be handled by investors that have niche knowledge.
Now that we have looked at what Exchange Traded Derivatives are and the various types of ETDs in which an investor can trade, the investors need to assess their risk appetite, ETDs investment history, sector’s current market scenario, and the background of the particular ETDs before trading in them.
Exchange Traded Derivatives do help in diversifying an investor’s portfolio. The Investor must make sure to select a trusted broking firm such as Angelone, which will provide multiple benefits such as trading account and Demat account, discounts on trading online, etc., to have a good investment experience.