Examples of exchange-traded derivatives

Derivatives traded on an exchange are only a kind of derivative contract whose value comes from the underlying assets listed on the exchange and guaranteed by the clearing house not to default. Because they exist on exchanges, ETDs are different from OTC derivatives in terms of standardized nature, higher liquidity, and ability to trade on the secondary market.

ETD includes futures contracts, option contracts and futures options. In the first half of 2020, the World Federation of Exchanges reported that the number of derivative contracts traded on global exchanges reached a record 21.72 billion, a year-on-year increase of more than 23%.

Key points

  • Exchange-traded derivatives (EDT) is a standardized financial contract, traded on an exchange, settled through a clearing house, and guaranteed.
  • One of the main features of exchange-traded derivatives that attract investors is that they are guaranteed by a clearing house, such as an option clearing company (OCC) or CFTC, thereby reducing the risk of the product.
  • Exchange-traded derivatives are listed on exchanges such as the Chicago Board of Options Exchange (CBOE) or the New York Mercantile Exchange (NYMEX), and are supervised by regulatory agencies such as the Securities and Exchange Commission.
  • EDT’s trading volume has steadily increased and reached a new high in 2020.

Interpretation of exchange-traded derivatives

Exchange-traded derivatives can be options, futures or other financial instruments listed and traded on regulated exchanges such as Chicago Mercantile Exchange (CME), International Stock Exchange (ISE), Intercontinental Exchange (ICE) or LIFFE Exchange. The contract is in London, just to name a few.

Exchange-traded derivatives are very suitable for retail investors, unlike their over-the-counter transactions. In the over-the-counter market, it is easy to get lost in the complexity of the tools and the exact nature of the transaction.

In this regard, exchange-traded derivatives have two major advantages:

standardization

The exchange has standardized terms and specifications for each derivative contract, allowing investors to easily determine how many contracts can be bought and sold. The size of each individual contract does not discourage small investors.

Eliminate the risk of default

The derivatives exchange itself, as the counterparty of every transaction involving derivatives traded on the exchange, effectively becomes the seller of every buyer and the buyer of every seller.This eliminates the risk that the counterparty to the derivative transaction may default

Another defining feature of exchange-traded derivatives is their mark-to-market feature, in which the gains and losses of each derivative contract are calculated on a daily basis. If the loss suffered by customers has eroded the margin, they will have to replenish the required capital in time, otherwise they will face the risk of selling their derivatives positions by the company.

futures

A futures contract is just a type of contract that specifies the buyer to buy or sell the underlying asset at a specific amount, price, and date in the future. Both hedgers and speculators use futures to prevent future price fluctuations of related assets or profit from them.

The futures exchanges can trade a wide range of products, with contracts ranging from agricultural products such as livestock, grains, soybeans, coffee and dairy products, to timber, gold, silver, copper, to energy commodities such as crude oil and natural gas, to stock indexes and volatility Indices, such as Standard & Poor’s, Dow Jones Indices, Nasdaq and Volatility Indices, as well as Treasury bills and foreign exchange rates for various major emerging markets and cross-currency pairs.

There are even futures based on predicted weather and temperature conditions. Depending on the exchange, each contract transaction has its own specifications, settlement and accountability rules.

A list of tradable futures contracts can be found on the CME Group website website.

Options

An option is a derivative tool that grants the holder the right to purchase or sell the underlying asset on a pre-designated date and amount, rather than an obligation. Since the first standardized contract trading in 1973, the options market has seen significant growth.For example, the Options Clearing Corporation (OCC) reported that nearly 830 million contracts were cleared in February 2021 alone, an increase of 47.4% compared to February 2020.The Chicago Board Options Exchange (CBOE) is the world’s largest options exchange, with an average daily trading volume of more than 10 million contracts in 2020, a record high.

Types of exchange-traded options

Stock option It is an option in which the underlying asset is the stock of a listed company. Stock options are usually standardized to 100 shares per contract, and the premium is quoted per share. For example, Apple Inc.’s (AAPL) 115 strike price call option that expires on March 20 will trade at $12.15 per share or $12.15 per option contract.

Index options The underlying asset is an option on a stock index; this Chicago Board Options Exchange Currently, S&P 500 and 100 index, Dow Jones index, FTSE 100, Russell 2000 and Nasdaq 100 index options are available. Each contract has different specifications, ranging from the approximate value of the underlying index to 1/10day scale. The Chicago Board Options Exchange also provides options for the MSCI Emerging Market Index and the MSCI EAFE Index.

ETF options It is an option in which the underlying object is an exchange-traded fund.

Volatility options It is a unique option, in which the subject matter is CBOE’s own index It tracks fluctuations in the price of S&P 500 index options. VIX can be traded through options and futures, as well as options for tracking VIX ETFs, such as iPath S&P 500 VIX short-term futures ETN (VXX).

Bond options The underlying asset is a bond option. Call option buyers expect interest rates to fall/bond prices rise, while put options buyers expect interest rates to rise/bond prices fall.

Interest rate options It is a European-style cash-settled option whose subject matter is the interest rate based on the spot yield of US Treasury bonds. Provides different options for bills that expire in different time spans. For example, the expected return of call option buyers will increase, and the expected return of put option buyers will decrease.

Currency options It is an option in which the holder can buy or sell currency in the future. Individuals and major companies use currency options to hedge foreign exchange risks. For example, if a U.S. company wants to receive euro payments in six months and is worried about the euro/dollar falling, for example, from 1.06 US dollars per euro to 1.03 US dollars per euro, they can buy euro/dollar put options with strikes per euro US$1.05 to ensure that they can sell euros at a better price in the spot market.

Weather options And (futures) are used by the company as a hedge to prevent adverse weather changes. They are different from catastrophe bonds that mitigate the risks associated with hurricanes, tornadoes, earthquakes, etc. Weather derivatives focus on daily or seasonal temperature fluctuations around a predetermined temperature benchmark.For more information on these derivatives, please visit CME Group website.

Futures options: As mentioned earlier, there are a variety of asset futures contracts, and exchanges like CME provide options contracts for the aforementioned futures. Holders of futures options have the right to buy or sell the underlying futures contract on a pre-designated date with a fraction of the margin requirements of the original futures contract.

Bottom line

Compared with over-the-counter (OTC) derivatives, exchange-traded derivatives offer more liquidity, transparency and lower counterparty risk at the cost of contract customization. The world of derivatives traded on the exchange includes futures, options and options on futures contracts.

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