# Exchange-Traded Derivatives: Understanding, Examples, and OTC Comparison

## What Is an Exchange-Traded Derivative?

An exchange-traded derivative is a financial contract that is traded on a regulated exchange. These contracts are popular for their standardization and liquidity. Common examples include futures and options, which investors use for hedging or speculation. Clearinghouses manage these trades, reducing the risk of default. Major exchanges and institutions offer these [derivatives](https://www.investopedia.com/terms/d/derivative.asp), which give participants a structured and secure market.

### Key Takeaways

*   Exchange-traded derivatives come with the benefits of standardization, which simplifies trading by providing consistent terms for each contract, making it more accessible to retail investors.  
    
*   These derivatives are settled through clearinghouses such as the Options Clearing Corporation, reducing the likelihood of default risk by acting as the counterparty in transactions.  
    
*   Exchange-traded derivatives offer transparency and regulatory oversight, which ensures reliability and fosters trust in financial markets, although this transparency may deter some large institutional investors.  
    
*   Futures and options, popular types of exchange-traded derivatives, allow for speculation and risk management across various assets, including commodities, equities, and currencies.

## How Exchange-Traded Derivatives Work

Exchange-traded derivatives include options, futures, and other financial contracts that are listed and traded on regulated exchanges such as the [Chicago Mercantile Exchange](https://www.investopedia.com/terms/c/cme.asp) (CME), [International Securities Exchange](https://www.investopedia.com/terms/i/internationalsecurityexchange.asp) (ISE), the [Intercontinental Exchange](https://www.investopedia.com/terms/i/intercontinentalexchange.asp) (ICE), or the [LIFFE](https://www.investopedia.com/terms/l/liffe.asp) exchange in London, to name a few.

Unlike their over-the-counter cousins, exchange-traded derivatives can be well suited for some [retail investors](https://www.investopedia.com/terms/r/retailinvestor.asp). 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:

### Standardization

The exchange has standardized terms and specifications for each derivative contract. This makes it easier for investors to determine essential information about what they're trading, such as the value of a contract, the amount of the security or item represented by a contract (e.g., lots), and how many contracts can be bought or sold.

Individual contracts can be a size that is less daunting for the small investor. For instance, an investor with limited capital could consider mini options (10 shares) on high-priced stocks versus standard options (100 shares).

### Elimination of Default Risk

The exchange itself acts as the [counterparty](https://www.investopedia.com/terms/c/counterpartyrisk.asp) for each exchange-traded derivative transaction. It effectively becomes the seller for every buyer, and the buyer for every seller. This eliminates the risk of the counterparty to the derivative transaction defaulting on its obligations.

Another defining characteristic of exchange-traded derivatives is their [mark-to-market](https://www.investopedia.com/terms/m/marktomarket.asp) feature. Mark to market means gains and losses on every derivative contract are calculated daily.

So, on any trading day, if the client incurs losses that erode the initial [margin](https://www.investopedia.com/terms/m/margin.asp) amount to a specific level, they will have to provide the required capital in a timely manner. If they don't, their derivative position may be closed out by the firm.

> **Tip**
>
> Financial futures are derivatives based on treasuries, indexes, currencies, and more. They're often used by financial institutions to hedge long positions held in the underlying security.

## Who Uses Exchange-Traded Derivatives?

Both small retail and large institutional investors use these derivatives to hedge portfolios and speculate on prices.

Banks might hedge the value of their treasuries portfolio by taking an opposite position in treasury futures. An import-export organization might use currency futures to lock in currency rates for impending transactions.

Retail investors might use stock options to hedge portfolios or earn premium income from selling options.

Most investors are reassured by the standardization and regulatory oversight offered by centralized exchanges.  

However, transparency might hinder large institutions that wish to keep their trading intentions private.

In fact, institutional investors might opt to work directly with issuers and investment banks to create tailored investments that give them the exact risk and reward profile they seek.

## What Information Does a Derivative Contract Include?

Generally, a contract will detail such things as the asset involved, the dollar value or amount (e.g., face amount or lot size) of the security, the settlement date and process, trading hours, price quotation, and the contract expiration date.

## What Are Some Types of Derivatives Traded on an Exchange?

Some exchange traded derivatives include stock options, currency futures, options and swaps, and index futures.

## Why Are Exchange Traded Derivatives Appealing to Investors?

Investors large and small appreciate the fact that these investments are understandable, reliable, and liquid. Contract features are clear. Parties to a contract must abide by it. Default risk is eliminated. Exchanges are regulated. Trust in financial markets translates to liquidity, which in turn means efficient access and pricing.

> **Article Sources**
>
> 1.  U.S. Securities and Exchange Commission. "[SEC Adopts Modernized Regulatory Framework for Derivatives Use by Registered Funds and Business Development Companies](https://www.sec.gov/news/press-release/2020-269)."
>     
> 2.  CFA Institute. "[Derivatives](https://www.cfainstitute.org/en/advocacy/issues/derivatives)."
>     
> 3.  Options Clearing Corporation. "[OCC at a Glance: A Brief Introduction](https://www.theocc.com/getmedia/9f694ba9-bf80-46e0-a655-7f9d06408040/OCC-ToolKit-OCC-AAG-ABriefIntro-030222.pdf)."