Exchange Traded Derivatives (ETD): Types, Features and Benefits
When it comes to risk management in investing, a smart way is to diversify your portfolio by investing in a wide variety of assets. In simpler terms, never keep all your eggs in one basket. In this regard, many traders prefer to purchase exchange traded derivatives as they are regulated, standardised and are indirect investment vehicles. They tend to have lesser risks than direct investments and are great for people who want to hedge or speculate asset price movements.
In this blog, you will get a detailed insight into exchange traded derivatives, their features and types. Read on to learn more!
Exchange Traded Derivatives – Meaning
Exchange traded derivatives (ETDs) are financial contracts that are tradable on the stock exchanges. They have an underlying asset which can range from stocks, bonds, commodities, currencies, etc., and the agreement derives its value from the price fluctuation of these securities.
These investment vehicles are regulated by the Securities and Exchange Board of India (SEBI) and you can purchase them on the exchanges. Exchange traded derivatives come in two forms – Options and Futures.
Features And Benefits of Exchange Traded Derivatives Contracts
ETDs come with a wide array of features and benefits which make them such a popular investment vehicle. Here are some of them:
- Regulated By Stock Exchanges
One of the biggest advantages of ETDs is that they are regulated by stock exchanges. Thus, buyers and sellers have to abide by a set of rules and regulations for trading with these contracts. This prevents big investors from gaining control over the market segment via unfair practices. In addition, the presence of market regulators also ensures the publishing of information on major trades that can benefit all investors.
- Standardised Contracts
Being under stock market regulations, ETDs undergo a high degree of standardisation. These contracts have a prefixed strike price, expiration date, lot size, settlement procedure and associated terms and conditions. Thus, there is uniformity among all derivatives contracts in this segment, making it easier for the authorities to keep a track of them.
- High Liquidity
Another significant benefit of exchange traded derivatives is high liquidity. This is due to the presence of several buyers and sellers in this market segment which makes it easier for traders to square off their positions.
For instance, investors can easily connect with counterparties and sell their holdings or make a reverse bet.
- Low Counterparty Risks
In case of exchange traded derivatives contracts, all dealings happen via an intermediary. This factor significantly reduces counterparty risks as the authorities can impose penalties for non-compliance with their rules.
- Ease of Offsetting Previous Contracts
While trading ETDs, traders also get the benefit of easily offsetting their previous agreements. This is because they can simply sell off their current position to a willing party in the market and buy an offset position, that too at a revised value.
What Are the Types of ETDs Available in the Indian Market?
In the Indian market, you can find the following exchange traded derivative contracts:
- Stock ETDs
When it comes to exchange traded derivatives, stocks are the most common underlying assets. There are several stock futures and options available in the market upon which you can take leveraged positions based on their price movements.
You can purchase stock ETDs from the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
- Commodity ETDs
These financial assets have commodities like gold, silver, copper, crude oil, natural gas, etc., as their underlying securities. Investing in them is an excellent way to expose your portfolio to the commodity segment without the risk of direct investments. You can purchase commodity ETDs from the Multi Commodity Exchange of India (MCX).
- Index ETDs
Index ETDs have major stock market indices as their underlying assets. They are a great way to gain exposure to multiple stocks from one investment. One thing to note on index derivatives assets is that physical delivery in this case is not possible. By default, these contracts have cash settlements.
Some indices on which investors generally prefer to purchase derivatives contracts are – S&P 500, Nifty 50, Sensex, Nasdaq and Nikkei.
- Bond ETDs
As the name suggests, this derivatives contract has bonds as its underlying asset. The National Stock Exchange has a dedicated trading platform for this product, from where you can buy and sell bond exchange traded derivatives.
- Currency ETDs
These investment vehicles allow you to conduct trades based on the price movements of various currencies that are present in the financial market. On the NSE, you will find standardised contracts for a specific combination of currencies. They are as follows:
- Indian Rupee vs Japan’s Yen (INR-JPY)
- Indian Rupee vs Euro (INR-EUR)
- Indian Rupee vs United States Dollar (INR-USD)
- Indian Rupee vs Great Britain Pound (INR-GBP)
- Real Estate ETDs
Real estate exchange traded derivative contracts allow you to trade in this sector without owning any physical investments. They have a decent trading volume in the market and serve as an excellent way to diversify portfolio risks.
To sum it up, exchange traded derivatives contracts come with a lot of benefits that can help you make profitable trades. However, before taking any decision, it is crucial for you to decide which sector/sectors you plan on investing in and assess their current market trends. Also, you should consider your own risk appetite before allocating funds.
Frequently Asked Questions
Q1. What is the difference between OTC and exchange traded derivatives?
Ans. Over-The-Counter (OTC) options are tradable privately between individuals and have flexible terms and conditions. They do not have any intermediaries and are not subject to market regulations. On the other hand, exchange traded derivatives undergo standardisation by market regulators and operate under strict rules.
Q2. How to trade derivatives options in India?
Ans. You can start trading derivatives by opening a trading account and a Demat account with a broker. Be sure to ask them whether they support futures and options trades and their associated charges. Moreover, if you plan to enter the commodities segment, you need a commodity trading account.
Q3. What are the risks of trading derivatives contracts?
Ans. Some of the potential risks associated with derivatives trading are contract duration and price volatility. If the underlying asset’s value does not rise within the expiry date, you may incur a loss. Additionally, due to significant market movements, the underlying security’s value can show massive fluctuations leading to significant losses.
Q4. Can non-resident Indians trade in the Indian derivatives market?Ans. Yes, non-resident Indians can participate in the Indian derivatives market. However, he/she needs to have a Non-Resident External (NRE) bank account and a Repatriable Demat account.