What are Exchange-Traded Derivatives?

Exchange-traded derivatives are common derivatives contracts like options or futures that are bought and sold by investors through a centralized exchange that regulates the transactions. This is in contrast to a so-celled over-the-counter derivatives market, in which the prices are determined by the buyers and sellers with no exchange involved. Investors who invest in exchange-traded derivatives are speculating on the prices of the securities that are underlying the contracts. Such investments, which include futures and options contracts, require less capital and offer more flexibility than typical stock trading.

The derivatives market is an ever-growing one that allows investors to become involved with securities without actually purchasing the actual assets involved. For example, someone who buys stock in a company actually purchases an ownership share in that company. By contrast, a derivative contract involving that asset might give someone the right to buy shares of the same company, but it could also be bought and sold without the investor ever actually owning shares in the company. Exchange-traded derivatives are a way for investors to participate in this market while benefiting from the transparency of a central exchange regulating all trades.

It is important to note that all exchange-traded derivatives must undergo severe scrutiny from the exchange in question, which means that the options for investors are more limited than what they might be able to get over the counter. They'll benefit, however, from being able to watch the prices on derivatives in real time on a market exchange. In addition, the amount of derivatives that meet regulatory standards is always growing.

By using exchange-traded derivatives, an investor can have access to some blue-chip securities that he might not otherwise be able to afford. This is because the prices for derivatives contracts are usually just a small percentage of the price of the underlying security. Investors can also get in and out of derivatives contracts for profits more quickly, as opposed to the relatively long period of time that it takes for stocks to become profitable.

Options and futures are the two main types of exchange-traded derivatives contracts available to investors. When an investor purchases an option, she has the right to buy or sell shares of an underlying security when it reaches a price known as the strike price, although she is not bound to exercise this option. By contrast, the holder of a futures contract is obligated to buy or sell shares of an underlying security at the current market price at some predetermined point in the future. With both options and futures, investors are speculating on the expected price movement of the underlying security.