Exchange trading derivatives - ETD meaning types and features
The first ever exchange-traded derivatives market was formed in the nineteenth century in Chicago, where the underlying asset was the commodity wheat. Farmers initiated this type of contract market to bring buyers closer to sellers of commodities. Soon personalized individual contracts were replaced by standardized ones regulated through a formal exchange. Derivatives have been instrumental in modernizing finance by providing access to capital to variously sized businesses. By eliminating counterparty risks and illiquidity, ETD is prioritized over OTC derivatives for the mandatory fulfilment of the contracts. They are now the traditional instruments to manage portfolio risks and link small margins with more considerable capital.
Additional read: What is the difference between ETD and OTC?
Types of ETD:
ETD are mainly options and futures contracts that are listed on and traded through intermediary public exchanges following their specific guidelines:
- Options contracts: Financial derivatives give the buyer and seller the right to transact an underlying asset in a standardized manner in terms of lot size and expiration date. But here, the counterparties are not obliged to sell or buy the asset on or before the expiration date.
- Futures contracts: Financial derivatives that pre-decide the price of an underlying asset to be sold or bought at a future date, regardless of the open market price of the purchase at that time.
Critical features of ETD:
- Standardization: Being regulated by the norms of a traditional exchange market, ETD contracts have specified lot sizes and expiration dates. It allows less room for counterparty negotiations after the contracts have been initiated and thus eliminate default risks.
- Low margins: Traders must pay only a tiny portion of the overall contract value (typically 5% - 10%). That allows small traders access to capital and also allows a general flow of money.
- Hedging: ETD contracts, often a combination of options and futures, allow traders to manage their portfolio risks by taking appropriate positions in the contracts.
- Speculation: ETD contracts allow speculations on the direction of the underlying asset's price movement in the future and adjust positions accordingly.
Specific features of options and futures ETD:
Options and futures are fundamental derivative instruments to manage market risks and diversify investment portfolios. Their key features are:
- Call and Put options: Options contract allows the counterparty to buy (call) or sell (put) the underlying security at a pre-decided price at a future date but without the obligation to do.
- High liquidity: Futures contracts mainly trade in assets whose value do not depreciate over time, like gold. They also trade in assets that can be most readily converted into cash.
Examples of ETD:
ETD contracts, whether futures or options, deal with a range of asset classes:
- Commodity: Where the underlying asset is wheat, corn, crude oil, etc.
- Stock index futures: Where the underlying asset is a specified quality of an individual stock. For example, S&P 500.
- Currency futures: Where the underlying currency is a specified quantity of a currency. For example, euro or dollar.
- Interest rate futures: Where the underlying currency is a specified quantity of an interest-bearing asset. For example, treasury bills or treasury bonds.
- Precious metal futures: The underlying currency is a specified quantity of gold, silver, or other precious metal.
Some disadvantages of ETD:
Despite being a popular financial instrument, ETD may incur these common drawbacks:
- High volatility: Though ETD contracts standardize prices and ensure contract fulfilment from counterparties, derivatives by themselves are highly volatile, and robust hedging and speculation to discover the future price of the underlying asset may be highly complex or impossible. For example, ETD contracts cannot protect against systemic failures, like the prolonged price drop of the pound (the underlying asset being a country's currency) post Brexit.
- Low margin and leverage issues: ETD contracts require a tiny margin of the original contract value. They can incur vast losses if price movements are not speculated correctly, leading to a margin drop below minimum levels.
ETD has been instrumental in modernizing finance by distributing access to traders of different capacities. It has differentiated the capital market with all kinds of players, thus ensuring the movement of capital through access. It is possibly the best market to pre-empt risks and maximize gains with minimal upfront costs.
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