Types of Derivatives in Exchange-Traded Funds (ETFs)

Certain kinds of exchange-traded funds (ETFs), including commodity ETFs, leveraged ETFs, and inverse ETFs, use derivatives instead of other types of assets to track the performance of their benchmarks. And many ETFs use a combination of derivatives and assets such as stocks. (Derivatives are financial instruments whose price is determined by the price of an underlying asset.)

The most common derivatives found in exchange-traded funds are futures, which are used particularly often in commodity ETFs so that actual physical commodities don't have to be taken possession of and stored. But ETFs also use forwards, swaps, and options (calls and puts).

Futures Contracts

A futures contract is an agreement between a buyer and a seller to trade a certain asset on a date that's predetermined by those involved in the transaction. The contract includes a description of the asset, the price, and the delivery date.

Futures are traded publicly on exchanges, and for that reason, they are highly regulated in the U.S. by the Commodity Futures Trading Commission. Because they are regulated, there is also no risk of either party defaulting on their obligation.

Futures are a very liquid type of derivative, meaning they're easily bought and sold, and investors can generally get into and out of futures positions rapidly.

Forward Contracts

A forward contract is similar to a futures contract, but it is not publicly traded on an exchange. Forwards are private agreements between a buyer and a seller. And since forwards are privately traded, they are typically unregulated as well, so there's a risk that either party to a contract may default.

One big advantage forwards have over futures is they can be customized to fit the exact needs of the buyer and seller, while futures are standardized, for example, to involve the exchange of exactly 5,000 bushels of corn.

Swap Contracts

A swap is a contract between a buyer and a seller to exchange multiple cash flows at pre-set future dates. The value of these cash flows is determined by a dynamic metric such as an interest rate, with one party receiving a set amount on each date and the other an amount that varies according to a reference rate.

Options Contracts

There are two types of options: calls and puts. A call option confers the right, but not the obligation, to buy a certain asset on or before an expiration date at a certain price. For example, the buyer of the call may be able to buy 100 shares of XYZ Corp. on or before the contract's expiration date at a price of $25 a share from the seller of the call. If the stock price rises above $25, the buyer would want to exercise their call option and buy the shares. If the stock price falls to $10, the buyer wouldn’t exercise their right to do so because they could buy the shares for less money on the open market.

A put option is the opposite of the call option. In this case, the buyer of the put has the right to sell 100 shares of XYZ at $25 each. If the stock price falls to $10, the buyer of the put would exercise their option to sell each of the 100 shares to the seller of the put for $15 more than its current value. If the stock price rises above $25, the buyer wouldn't want to sell the stock to the seller of the put for less than they could receive on the open market, so the buyer would let the put expire worthless.