An exchange-traded derivative (ETD) is simply a derivative contract whose value is derived from an underlying asset that is listed on a trading exchange and is insured against default by a clearinghouse. ETDs vary from OTC derivatives in terms of their standardized nature, increased liquidity, and ability to be traded on the secondary market due to their inclusion on a trading exchange.
Futures contracts, options contracts, and futures options are all examples of ETDs. The Globe Federation of Exchanges stated that a record 29.24 billion derivative contracts were traded on exchanges throughout the world in the first half of 2021, up more than 18% from the previous quarter.
- An exchange-traded derivative (ETD) is a standardized financial contract that is traded on an exchange and settled via a clearinghouse.
- The fact that exchange-traded derivatives are insured by clearinghouses such as the Options Clearing Corporation (OCC) or the Commodity Futures Trading Commission (CFTC) reduces the product’s risk.
- Exchange-traded derivatives are traded on exchanges such as the Cboe Global Markets (Cboe) or the New York Mercantile Exchange (NYMEX) and are regulated by agencies such as the United States Securities and Exchange Commission (SEC).
- EDT volumes have constantly increased, hitting new highs in 2021.
Exchange-Traded Derivatives Explained
Options, futures, and other financial contracts that are listed and traded on regulated exchanges such as the Chicago Mercantile Exchange (CME), International Securities Exchange (ISE), Intercontinental Exchange (ICE), or the London Stock Exchange (LIFFE) are examples of exchange-traded derivatives.
Unlike its over-the-counter counterparts, exchange-traded derivatives are ideally suited for ordinary investors. It is easy to get disoriented in the OTC market due to the intricacy of the instrument and the precise nature of what is being exchanged.
Exchange-traded derivatives offer two significant benefits in this regard:
Each derivative contract on the market has uniform terms and specifications, making it simple for investors to calculate how many contracts may be purchased or sold. Each individual contract is likewise of a manageable size for the novice investor.
Elimination of Default Risk
The derivatives exchange itself serves as the counterparty in any transaction involving an exchange-traded derivative, thereby acting as the seller for every buyer and the buyer for every seller. This reduces the chance that the derivative transaction’s counterparty would fail on its commitments.
Another distinguishing feature of exchange-traded derivatives is their mark-to-market function, which calculates profits and losses on each derivative contract on a daily basis. If the customer has sustained losses that have reduced their arginput, they must replace the needed capital in a timely way or risk the company selling off the derivative position.
A futures contract is simply a contract in which a buyer or seller agrees to buy or sell an underlying asset at a predetermined amount, price, and date in the future. Futures contracts are used by both hedgers and speculators to guard against or benefit from future price variations in the underlying asset.
Contracts range from agricultural products such as livestock, grains, soybeans, coffee, and dairy to lumber, gold, silver, copper, and energy commodities such as crude oil and natural gas, as well as stock indices and volatility indices such as the S&P, Dow, Nasdaq, and VIX, as well as interest rates on Treasury notes and foreign exchange for a diverse array of major emerging markets and cross currency pair.
There are also futures contracts based on weather and temperature forecasts. Each contract is exchanged with its own specifications, settlement, and accountability requirements, depending on the exchange.
On its website, CME Group provides a comprehensive list of marketable futures contracts.
Option contracts provide the holder the right, but not the responsibility, to purchase or sell an underlying asset at a certain date and quantity. Since the first standardized contract was exchanged in 1973, the options market has grown dramatically.
For example, the Options Clearing Corporation (OCC) reported clearing approximately 830 million contracts in February 2021 alone, an increase of 47.4 percent over February 2020. The Cboe Global Markets (Cboe) is the world’s biggest options exchange, with an average daily volume of more than 12 million contracts in 2021, another record.
Types of Exchange-Traded Options
Equity options are options in which the underlying asset is a publicly traded company’s shares. Stock options are typically standardized at 100 shares each contract, with the premium specified per share. An Apple Inc. (AAPL) 115 strike call option with a March 20 expiration is trading for $12.15 per share, or $1,215 per option contract (1 contract = 100 shares).
Index options are options using a stock index as the underlying asset; the Cboe now provides options on the S&P 500 and 100 indexes, the Dow Jones, the FTSE 100, the Russell 2000, and the Nasdaq 100. Each contract had unique characteristics and may vary in size from the approximate value of the underlying index to one-tenth the size. The CBOE also provides options on the MSCI Emerging Markets Index as well as the MSCI EAFE Index.
ETF options are options with an exchange-traded fund as the underlying.
The underlying of VIX options is the Cboe’s own index, which measures the volatility of S&P 500 index option prices. The VIX may be traded using options, futures, and options on ETFs that follow the VIX, such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX).
Bond options are options with a bond as the underlying asset. The call buyer expects interest rates to fall/bond prices to increase, while the put buyer expects interest rates to rise/bond prices to fall.
Interest rate options are cash-settled European-style options with an underlying interest rate based on the spot yield on US Treasurys. Varying choices are available for bills with different maturities; for example, a call buyer expects yields to climb while a put buyer expects yields to fall.
Currency options allow the holder to purchase or sell currency in the future. Individuals and huge corporations utilize currency options to hedge against foreign exchange risk. For example, if an American company expects to receive payment in euros in six months and is concerned about a drop in the EUR/USD, say from $1.06 per euro to $1.03 per euro, they can buy a EUR/USD put with a strike price of $1.05 per euro to ensure they can sell their euros at a better price on the spot market.
Companies utilize weather options and (futures) as hedges against adverse weather fluctuations. They are not the same as catastrophe bonds, which reduce the risks connected with hurricanes, tornadoes, earthquakes, and other natural disasters. Weather derivatives, on the other hand, concentrate on daily or seasonal temperature changes around a fixed temperature benchmark. CME Group provides a wide range of weather derivatives.
Futures options: As previously stated, there are futures contracts for a number of assets, as well as exchanges such as the CME that sell options contracts on those futures. The holder of a futures option has the right to purchase or sell the underlying futures contract on the designated date for a fraction of the margin required for the original futures contract.
The Bottom Line
At the expense of contract customisation, exchange-traded derivatives provide greater liquidity, transparency, and reduced counterparty risk than over-the-counter (OTC) derivatives. Futures, options, and options on futures contracts are examples of exchange-traded derivatives.
Investopedia does not provide tax, investment, or financial advice. The material is offered without regard for any individual investor’s investing goals, risk tolerance, or financial circumstances, and may not be appropriate for all investors. Investing entails risk, including the possibility of losing money.
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