Futures vs. Options
What’s the Difference?
The cryptocurrency space has seen tremendous growth since the crash in March 2020. As more users adopt cryptocurrencies for trading and investment purposes, there has been a rise in demand for various financial tools like cryptocurrency futures and options. While these products already exist in the traditional marketplace, there are many traders who are still unaware of the benefits of these products and the different ways in which they can be used.
While both futures and options contracts allow users to buy or sell a product in future, there is a difference between the two products. This article has been written to explain the difference between cryptocurrency futures and options.
Introduction to Futures and Options Trading
At the time of writing the total market capitalization of crypto markets is $1.3T, with Bitcoin having a market capitalization of ~$600B. This results in the volatility in the price of several cryptocurrencies, including Bitcoin. Futures and options trading could then be used by traders and investors to not only speculate about the price movement of different tokens but also hedge their risks as per their strategies. The chart below shows how the price of Bitcoin has changed since 2020. Bitcoin’s volatility tends to make common investors nervous about investing in it. With Bitcoin dominance being more than 44% it is evident that most of the cryptocurrencies will follow the price action of Bitcoin. In order to truly develop the crypto markets, robustly designed financial products such as futures and options are necessary to promote the confidence of token holders.
It all began with “Forward Contracts” where a buyer agrees to purchase a financial asset at a future date and at a specified price. The price of this asset and the trade date is agreed beforehand and is termed as a forward contract. Some of the risks associated with forward contracts were default risks, liquidity risk and regulatory uncertainty. This led to the creation of futures contracts which paved the way for options contracts. Futures and options contracts come with their own risk and traders use either of them based on their risk tolerance and liquidity considerations.
So what are futures contracts? Why do we need them? Continue reading to get your answers.
What are Futures contracts?
A future is a standardized contract that gives you the right and the obligation after buying it, to buy or to sell a commodity in the future, at a fixed price settled when signing the contract. It is used in all sorts of industries such as oil, agriculture and even cryptocurrencies. Signing a futures contract requires no fees but the contract must be executed. This feature is the “obligation” part of the contract.
Future trading can be done for long term as well as short term purposes. If you expect the price of a certain cryptocurrency to fall, then you must short the token. This means you are selling the token at the current market price and will buy it back in future at the lowest possible price you are aiming for. Anyone who believes that the price of a cryptocurrency will be higher than the current market price, the token must be longed meaning you buy the token at today’s price and sell it at the highest possible price.
Traders also gain access to leverage in most futures markets. Leverage is a strategy that allows you to trade futures contracts without having to pay upfront the full value of a contract. Traders can borrow the needed capital to finance the contract with a relatively smaller equity stake.
For example, Alice believes that the price of ETH will rise to $5000 in the next few weeks and the current price of ETH is $2500. She can take a leveraged position based on her risk appetite. A 1x position means she does not want to take any risk, whereas a 100x position means it is a very risky position. Suppose she is confident with her assumption and would like to enter the position with a $250 payment. This means that her position has been leveraged 10 times. As long as the price of ETH is rising, she is making money. In case the price of ETH falls below $2250, her order will automatically get liquidated and she will lose her investment of $250.
The above is an example of perpetual contracts. Then there are contracts with a given expiry date.
For example, Beth wants to buy BTC and expects that it will increase in the future. He decides to buy a futures contract on one of the futures trading platforms.
The price of one BTC is $30,000, he plans to buy 10 BTC. Consider, the cost for a single contract is $300.
Contract Cost = Number of contracts x Cost of each contract
In this scenario, he wants to buy 10 BTC, so the number of contracts is 10
Therefore,
Contract Cost = 10 x 300 = $3,000
Order Value = Cost of the contract / Entry price
Entry price is the current price of BTC, i.e. $30,000
= 3000/30000
Order Value = 0.1 BTC
Therefore, 0.1 BTC is the initial margin amount for a contract.
If he did not execute the contract on the expiry date, it is automatically designed to execute by calculating the average price in the last hour. Beth needs to pay an extra fee for the automatic contract execution.
What are Options Contracts?
Our previous guide to options trading covers everything you need to know about options trading, the different examples for call and put options and the different kinds of greeks in options trading.
As mentioned in the guide, an option, in general, is a contract giving the buyer the right, but not the obligation, to buy (in the case of a call option contract) or sell (in the case of a put option contract) the underlying asset at a specific price on or before a certain date. Unlike futures contracts, option contracts are more flexible, since one can exercise an option contract whenever one wants during the time period between the contract signature and the expiration date. The value for the contract depends on various factors including the time of expiry. The longer the time period till the option expiry, the higher will be the premium.
Now that we understand Futures and Options trading, let us now understand the difference between futures and options.
Difference Between Cryptocurrency Futures Trading and Options Trading
- The key difference is that futures contracts give you the obligation to buy or sell the underlying asset whereas options contracts only give you the right but not the obligation to buy or sell the asset.
- The risk involved in the options trading is lesser than the future trading. This is because for the buyer of an option, the maximum amount of loss is the premium and the contract does not get liquidated in any way. For a futures contract, since the buyer is obligated to buy or sell the underlying asset, this might lead to huge losses if the trade does not go in their favour.
- There are no limits to profit or loss in futures contracts whereas there can be a limited loss but high profits in the case of options trading.
- Crypto futures contracts are cost-effective in the sense that there is no upfront cost for the contracts, unlike options contracts which comprise premium payments in advance.
- Futures contracts do not suffer from time decay, unlike options that become less valuable as the expiration date draws closer.
Conclusion
While both tools have their own advantages and disadvantages, they can be a blessing in disguise if used correctly. Using either of these financial tools depends on traders’ preferences. While crypto futures offer you a large market to trade in, crypto options offer you a low-risk market. It is therefore important to understand how to manage risks before diving or putting money into such complex financial instruments.
About Oddz
Oddz is a trustless on-chain derivatives trading platform that expedites the execution of call and put options contracts, conditional trades, and futures. It allows the creation, maintenance, execution, and settlement of trustless option contracts, conditional tokens agreements, and futures contracts in a fast, secure, and flexible manner.
It employs the synergies of Ethereum, Binance Smart Chain, Polkadot, Polygon, Elrond Network and Chromia to unleash the potential decentralized derivatives market. It focuses on building solutions that can propel the DeFi ecosystem by simplifying derivatives trading and enhancing the user experience.
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