Are you still confused about the key differences between Futures and Options contracts? Don’t worry, any confusion will be cleared up in this article, which will address what differentiates the two types of derivative contracts, as well as in which way they’re similar. Let’s waste no more time and dive right into it!
What are Derivative Contracts?
Both options and futures contracts are a type of derivatives. As the name implies they ‘derive’ their value from something else and that something is the underlying asset. For instance, in the case of Bitcoin futures or options, the contract's value is based on the price of Bitcoin, but in the broader sense the underlying asset might also be stocks, indexes, bonds, commodities or even interest rates.
What are they used for? Derivatives can be used to either mitigate risk or take on additional risk in order to maximise reward. If you want to reduce the risk of adverse price movements in an asset (also called hedging) you take an offsetting or opposite position in a related security, meanwhile if you want to expose yourself to additional risk in order to secure bigger profits, you can do so by using derivatives that enable a lot of leverage.
What are Futures Contracts?
They are derivative products through which buyers and sellers agree to trade at a pre-established price and date. The contracts you trade in the futures market do not carry the true value of the cryptocurrency you use. This means that you do not own the underlying cryptocurrency, but rather just a contract that tracks its price.
In the futures market participants can go either long or short. You go long when you want to make a buck from a price increase, while going short gives you the ability to profit from price drops. Regardless of the direction, once the pre-agreed date comes and the contract expires, both parts of the contract settle. This is not necessarily true for all types of futures, since there are two types: futures with a set expiration date and futures that don’t expire that are called perpetual futures.
For the sake of this article we’ll focus solely on futures with an expiration date and leave their comparison with Perpetual futures for one of the upcoming articles. The most popular of these are quarterly futures, which usually expire on the last Friday of each quarter. The name of the contract includes the expiry date, so for example, a BTC-25MAR22 contract is the Q1 contract that expires on the last Friday of the quarter, which is on 25 March.
This means that if you, for example, purchase one BTC-25MAR22 now, for a price of $39,000. The price of this contract will fluctuate with the price of Bitcoin, until the expiry date. Finally, on 25 March, the contract will be settled, which means that you will buy 1 BTC for $39,000 regardless of the price of Bitcoin at that time.
Contracts can be settled in two different ways, via physical settlement or cash settlement, the latter being far more popular. In the first case, you would literally buy 1 BTC for $39,000, while in the second case you would only get the cash difference between the futures contract price and price of the underlying asset (in this case BTC) at the time of expiry. For instance, if Bitcoin was trading at $45,000 at the time of expiry, you would earn $6,000. It’s also possible to close your position before the expiry and your profit (or loss) would then be the difference between the futures contract prices at the time you opened and closed your position.
Trading futures also gives you access to leverage, which 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 and buy up to 50-100 times more expensive contracts than the value of your portfolio, which magnifies profits as well as losses in case things don’t turn out the way you wished for.
What are Options contracts?
On the one hand options and futures are both derivative contracts, which represent agreements to buy or sell the underlying asset on a future date and at a specific price (the strike price), allowing investors to make money or hedge their current positions. On the other hand, in contrast to a futures contract that requires a buyer to purchase shares and a seller to sell, when the contracts expire (unless the holder's position is closed before the expiration date), an options contract gives an investor the right, but not the obligation, to buy (or sell) shares at a specific price at any time, as long as the contract is in effect. Another difference in comparison to futures, where the price of the future purchase is determined by current market price, is that when it comes to options the price of the future purchase is specified in the contract.
Options are divided into two types of options: calls and puts. Call options refer to options that enable the option holder to buy an asset, while put options enable the holder to sell an asset. The price at which the buyer buys and the seller sells the underlying asset at the pre-specified time is called Strike price, whereas the price of the contract itself is called premium. The amount you pay for the premium is the most you can lose (maximum negative PnL), which makes options a little less risky than futures, where having a too large negative PnL can get you liquidated in case the price moves against you. Let’s look at a concrete example in order to clear up things. Assuming that Bitcoin is currently trading at $40,000 and you buy one call option contract BTCM22 with an expiry date on June 24 (at the end of Q2 2022), a strike price of $38,000 and a premium of $10,000. In such a scenario, you would need to immediately pay the $10,000 premium, in exchange for which you would gain the right to buy 1 BTC for $38,000 on June 24. If Bitcoin was trading at $48,000 at the time of expiry, you would break even (you’ll make $10,000, but this is also the premium you paid at the beginning), while for every dollar above $48,000 you would have a dollar of profit (and vice versa the other way around). If the price of Bitcoin is under $40,000 on the expiration date, you will choose not to exercise the option, of course, and it will expire worthless, meaning that your total loss would be the premium you paid at the beginning- $10,000. The interesting thing about options contracts is that you can never lose more than the premium that you pay at the beginning. Consequently they offer a great way to hedge your positions. Imagine that in the previously outlined scenario, Bitcoin dropped to 15,000$ at the time of options expiry. Under such circumstances, your total loss would still be only the amount you paid for the premium at the beginning - $10,000. Conclusion I hope that this blog gave you a better insight into fundamental differences and similarities between the two different financial instruments. Precursors to derivatives have been around since ancient times, but that doesn’t mean that they aren’t rather complex and misunderstood by lots of market participants. Therefore we’ll release more detailed blogs about more specific strategies and aspects in the future. And of course, since these are more complex financial instruments, we suggest you first get comfortable spot trading crypto in addition to getting knowledgeable on the topic, before exploring the world of options and futures.