Derivatives are of two types - over-the-counter and standardised contracts. While over-the-counter derivative transactions take place privately between two parties, exchange-traded derivatives are standardised contracts overseen and controlled by a stock exchange, such as the National Stock Exchange (NSE). This article defines exchange-traded derivatives and provides examples to understand the concept better.
What Are Exchange-Traded Derivatives?
Exchange-traded derivatives generally refer to futures and options instruments traded through a public exchange, such as NSE. It is a standardised contract with a strike price, expiry date, option contract type (European or American), underlying instrument, lot size, etc. Let's understand each in detail:
1. Strike Price - The price asked for by the seller of the derivatives contract
2. Expiry Date - The last day of a derivatives contract, usually the last Thursday of every month
3. Options Contract Type - While European-type Options contracts can be exercised on the expiry date, American-type options can be exercised any time before the expiry date
4. Underlying Instrument - The underlying instrument may be an index, share, commodity, or currency
5. Lot Size - Lot size refers to the minimum quantity of the underlying instrument you need to buy
In exchange-traded derivatives, the exchange acts as a counterparty and hence, there is no risk of bad trades or malpractices. Almost all exchange-traded derivatives are transparent and liquid.
Examples of Exchange-Traded Derivatives
The following are the most common examples and types of exchange-traded derivatives you can find in India:
The Securities and Exchange Board of India (SEBI) periodically publishes the list of stocks in the Futures & Options (F&O) segment. Investors and traders select the strike price of a stock derivative and place four types of trades - buy call, sell call, buy put, sell put. The contract price depends on the movement of the stock. You can check the complete list of F&O stocks here.
NIFTY and BANKNIFTY are the two most popular index derivatives in India. When you invest in an index derivative, you essentially invest in all stocks part of that index. For example, NIFTY consists of the top-50 stocks in the Indian capital market.
The fifty stocks collectively decide the movement of the index. When you buy or sell NIFTY (or any other index derivative), you invest in the stocks that compose the index. Interestingly, you can trade an index only through derivatives since the physical delivery of such instruments is impossible.
Some currency pairs are available for derivatives trading through an exchange. You can enter these currency pairs through futures or options. Also, like stock and index derivatives, you can go long or short on these trades.
Commodities like crude oil, natural gas, gold, silver, etc., can be traded through exchange-traded derivatives. Commodities derivatives trades are generally secured and backed by physical commodities. You can go long or short on these trades.
Real Estate Derivatives
Real estate derivatives were the prime cause of the 2008 Global Financial Crisis. These exchange-traded derivatives are generally less liquid than stocks, index, or commodities derivatives.