An exchange-traded derivative is merely a derivative contract that derives its value from an underlying asset that is listed on a trading exchange and guaranteed against default through a clearinghouse. Due to their presence on a trading exchange, ETDs differ from over-the-counter derivatives in terms of their standardized nature, higher liquidity, and ability to be traded on the secondary market.
ETDs include futures contracts, options contracts, and futures options. In the first half of 2020, the World Federation of Exchanges reported that a record 21.72 billion derivative contracts were traded on exchanges around the world, up more than 23% from the previous period.
- An exchange-traded derivative (EDT) is a standardized financial contract, traded on an exchange, that settles through a clearinghouse, and is guaranteed.
- A key feature of exchange-traded derivatives that attract investors is that they are guaranteed by clearinghouses, such as the Options Clearing Corporation (OCC) or the CFTC, reducing the product's risk.
- Exchange-traded derivatives are listed on exchanges, such as the Chicago Board Options Exchange (CBOE) or New York Mercantile Exchange (NYMEX), and overseen by regulators, like the Securities and Exchange Commission.
- Volumes for EDTs have risen steadily, reaching new highs in 2020.
Exchange-Traded Derivatives Explained
Exchange-traded derivatives can be options, futures, or other financial contracts that are listed and traded on regulated exchanges such as the Chicago Mercantile Exchange (CME), International Securities Exchange (ISE), the Intercontinental Exchange (ICE), or the LIFFE exchange in London, to name just a small few.
Exchange-traded derivatives are well suited for the retail investor, unlike their over-the-counter cousins. In the OTC market, it is easy to get lost in the complexity of the instrument and the exact nature of what is being traded.
In that regard, exchange-traded derivatives have two big advantages:
The exchange has standardized terms and specifications for each derivative contract, making it easy for the investor to determine how many contracts can be bought or sold. Each individual contract is also of a size that is not daunting for the small investor.
Elimination of Default Risk
The derivatives exchange itself acts as the counterparty for each transaction involving an exchange-traded derivative, effectively becoming the seller for every buyer, and the buyer for every seller. This eliminates the risk that the counterparty to the derivative transaction may default on its obligations
Another defining characteristic of exchange-traded derivatives is their mark-to-market feature, wherein gains and losses on every derivative contract are calculated on a daily basis. If the client has incurred losses that have eroded the margin put up, they will have to replenish the required capital in a timely manner or risk the derivative position being sold off by the firm.
A futures contract is merely a contract specifying that a buyer purchases or a seller sells an underlying asset at a specified quantity, price, and date in the future. Futures are used by both hedgers and speculators to protect against or to profit from price fluctuations of the underlying asset in the future.
A myriad of products can be traded on the futures exchanges, with contracts ranging from agricultural products such as livestock, grains, soybeans, coffee, and dairy to lumber, gold, silver, copper to energy commodities such as crude oil and natural gas to stock indices and volatility indices such as the S&P, the Dow, Nasdaq, and the VIX, as well as interest rates on Treasury notes and foreign exchange for a diverse array of major emerging markets and cross currency pairs.
There are even futures based on forecasted weather and temperature conditions. Depending on the exchange, each contract is traded with its own specifications, settlement, and accountability rules.
Options are derivatives that grant the holder the right, but not the obligation, to buy or sell an underlying asset at a pre-specified date and quantity. The options market has seen remarkable growth since the first standardized contract was traded in 1973. For instance, the Options Clearing Corporation (OCC) reported clearing nearly 830 million contracts in the month of February 2021 alone, up 47.4 percent compared to February 2020. The Chicago Board Options Exchange (CBOE) is the largest options exchange in the world, with an average daily volume in 2020 of more than 10 million contracts, another record.
Types of Exchange-Traded Options
Equity options are options in which the underlying asset is the stock of a publicly-traded firm. Stock options are normally standardized into 100 shares per contract, and the premium is quoted on a per-share basis. For instance, an Apple Inc. (AAPL) 115 strike call option for March 20 expiry is being traded for $12.15 per share or $12.15 per option contract.
Index options are options in which the underlying asset is a stock index; the CBOE currently offers options on the S&P 500 and 100 indices, the Dow Jones, FTSE 100, Russell 2000, and the Nasdaq 100. Each contract had different specifications and can range in size from the approximate value of the underlying index to 1/10th the size. The CBOE also offers options on MSCI Emerging Markets Index, the MSCI EAFE Index.
ETF options are options in which the underlying is an exchange-traded fund.
VIX options are unique options in which the underlying is the CBOE’s own index which tracks the volatility of the S&P 500 index option prices. The VIX can be traded via options and futures, as well as through options of the ETFs that track the VIX, such as, the iPath S&P 500 VIX Short-Term Futures ETN (VXX).
Bond Options are options in which the underlying asset is a bond. The call buyer is expecting interest rates to decline/ bond prices to rise and the put buyer is expecting interest rates to climb/bond prices to fall.
Interest Rate Options are European-style, cash-settled options in which the underlying is an interest rate based on the spot yield of US Treasurys. Different options are offered for bills expiring at different time spans, e.g. a call buyer is expecting yields to rise and a put buyer is expecting yields to decline.
Currency Options are options in which the holder can buy or sell currency in the future. Currency options are used by individuals and major businesses to hedge against foreign exchange risk. For instance, if an American company is expecting to receive payment in euros in six months’ time and fears a drop in the EUR/USD, say from $1.06 per euro to $1.03 per euro, they can purchase a EUR/USD put with a strike of $1.05 per euro to ensure they can sell their euros at the spot market for a better price.
Weather Options and (futures) are used as hedges by companies to guard against unfavorable weather changes. They are not the same as catastrophe bonds that mitigate the risks associate with hurricanes, tornadoes, earthquakes, etc. Weather derivatives instead focus on daily or seasonal temperature fluctuations around a predetermined temperature benchmark. More information on these derivatives can be found at the CME Group’s website.
Options on Futures: As previously mentioned, there are futures contracts for a variety of assets, and exchanges like the CME that offer options contracts on said futures. The futures options holder is entitled to buy or sell the underlying futures contract at the pre-specified date at a fraction of the margin requirement of the original futures contract.
The Bottom Line
Exchange-traded derivatives offer more liquidity, transparency, and lower counterparty risk than over-the-counter (OTC) derivatives at a cost of contract customization. The exchange-traded derivatives world includes futures, options, and options on futures contracts.