Comparing Futures and Options: How to Choose?

Trading Made Easy 2023-10-19 19:37:10

Participating in the dynamic world of financial markets offers excitement and the potential for substantial rewards. Yet, with a myriad of options available, making the right choice can be a daunting task. Among the array of possibilities, futures and options contracts stand out as investment avenues capable of delivering leveraged returns. Both fall under the category of derivatives, financial instruments whose value derives from an underlying asset, whether it's a stock, commodity, or cryptocurrency. However, these two financial tools diverge significantly and cater to distinct investor profiles. So, which of them aligns best with your investment objectives?


In this comprehensive guide, we'll dissect the disparities between futures and options contracts, equipping you with the knowledge needed to make an informed decision. Buckle up and prepare to embark on a journey to unlock the potential of these formidable financial instruments.

Understanding Crypto Futures Contracts

Crypto futures contracts represent agreements between two parties to buy or sell an underlying asset at a predetermined price and a specific date in the future. These contracts provide a means for investors to engage in cryptocurrency trading without actually owning the digital assets.


While sharing similarities with traditional futures contracts, crypto futures stand out by employing cryptocurrencies as their underlying assets. Unlike their conventional counterparts, crypto futures are characterized by their elevated volatility, the availability of leverage, and round-the-clock trading opportunities.


Crypto futures open up the potential for investors to profit both from rising and falling cryptocurrency markets, making them an enticing option for those with a solid grasp of the crypto landscape and a tolerance for increased risk.


Traders have the flexibility to assume either long or short positions based on their market outlook. Long positions are commonly adopted by those anticipating price increases, while short positions are taken by traders seeking to capitalize on price declines.


At the contract's maturity, the trader's profit or loss hinges on the settlement price, which is determined by the spot price of the underlying cryptocurrency. Should a trader opt to close the futures position before its maturity date, the profit or loss will be determined by prevailing futures market prices at the time of unwinding.


Diverging from traditional spot or cash assets, futures typically operate on margin, granting traders access to potentially significant gains with comparatively modest capital. The margin operates in two key ways:


  1. Initial Margin: This represents the minimum cash percentage required to initiate a position.


  1. Variation or Maintenance Margin: This indicates the funds necessary to maintain the initial margin, contingent on fluctuations in the value of the underlying asset.


Futures predominantly revolve around the price of an asset at a predetermined future date, akin to forward contracts, although this isn't universally the case.

Types of Crypto Futures Contracts

Standard Futures Contract

Standard crypto futures contracts operate similarly to their traditional counterparts, governing trades in cryptocurrencies at predetermined prices and specified future dates. They share resemblances with standard futures contracts found in traditional markets, including comparable mechanisms for expiry and settlement.


Typically, these contracts come with monthly (serial) or quarterly (quarterly) expiration dates. Upon reaching the expiration date, positions are concluded through a settlement process, which we'll delve into shortly. As an example, the CME Group introduced Bitcoin futures contracts settled in USD every three months.


When engaging in standard futures trading, it's essential to keep the following points in mind:


  • To maintain a long-term position, traders need to "roll" the contract forward before it expires.


  • To execute this, traders must close their active contract (front month) and initiate a corresponding position in a more distant forward futures contract (back month).


Additionally, it's crucial to acknowledge that asset prices typically undergo changes over time. Consequently, futures contracts are priced using a forward curve.


  • For assets anticipated to appreciate, the prices of forward contracts increase as they extend into the future, a condition known as "contango."


  • Conversely, for assets expected to depreciate, the prices of forward contracts decline as they progress into the future, referred to as "backwardation."


Due to these price dynamics, the values of futures contracts with different maturities (expiration dates) can exhibit substantial fluctuations, presenting challenges in managing long-term positions, particularly as the contract nears its expiration (run-off).


Physical Delivery Futures

Physical delivery futures represent futures contracts where the underlying cryptocurrency is physically transferred to the buyer upon contract expiration. These contracts cater to individuals seeking actual ownership of the cryptocurrency, as opposed to those merely speculating on its price fluctuations.


Perpetual Futures (Perps)

In the realm of cryptocurrencies, perpetual futures contracts are linear contracts that lack predefined expiration dates. Similar to standard crypto futures contracts, they enable traders to assume long or short positions on cryptocurrency prices, allowing them to profit from market fluctuations without the need to possess the underlying asset physically. However, unlike traditional futures, perpetual futures have no expiration date.


Trading perpetual futures carries two primary advantages over traditional futures contracts:


  • Traders can maintain long-term holdings without the need to continuously roll their positions forward before contract expiry, reducing basis risk.


  • A funding mechanism ensures that the futures price remains closely aligned with the spot price of the underlying asset. This mechanism involves regular payments, occurring every 8 hours to or from long or short traders based on the disparity between perpetual contract markets and spot prices.


The perpetual futures funding mechanism serves as an incentive for traders to buy futures when the price is low compared to the underlying spot market. Conversely, high funding rates incentivize traders to sell futures. This dynamic creates a risk-free arbitrage opportunity if the futures price diverges significantly from the underlying asset.


For instance, if the BTC funding rate is positive (longs pay shorts), traders can theoretically sell BTC futures contracts while simultaneously buying an equivalent amount of BTC in the spot market to hedge their position. This strategy allows them to collect funding fees while ensuring the futures price remains tethered to the underlying asset.


Inverse Futures

Inverse perpetual contracts enable traders to use cryptocurrencies like BTC as the base currency. These contracts differ from linear perpetual futures as they employ various cryptocurrencies as collateral, and their payoff, margin requirements, and profit and loss calculations are distinct.


Settlement Methods for Futures Contracts

Futures contracts typically employ one of two settlement methods:


  1. Physical Settlement: Upon reaching the expiration date, you are obligated to either take delivery (for long positions) or make delivery (for short positions) of the underlying asset.


  1. Cash Settlement: Upon contract expiry, the investor's account is adjusted by debiting or crediting the difference between the trade's opening price and the contract's settlement price.

Understanding Crypto Options Contracts

Crypto options contracts, akin to crypto futures, are financial agreements linked to the value of an underlying digital asset. These contracts grant traders the option to purchase or sell the asset at a predetermined price on a future date. However, in contrast to crypto futures, options contract holders possess the right but are not bound to buy or sell the underlying asset upon contract maturity.


Crypto options contracts serve as a means for holders to mitigate the risk of losses and steer clear of forced liquidations often associated with futures contracts. In exchange for this feature, buyers are required to remunerate the option's writer with a non-refundable initial fee or premium.


In the crypto market, several types of options contracts exist, with call and put options being the two most prevalent varieties.


Optimal Situations for Utilizing Options

The allure of options lies in their versatility, as they can be harnessed to generate profits across a spectrum of market conditions. Regardless of whether you anticipate an upward, downward, or sideways movement in the underlying asset's price, options offer a strategy tailored to your expectations.


However, when dealing with options, it's important to grasp that there's more to consider than mere price direction. Rather than making a straightforward bet on whether the price will ascend, descend, or remain steady, options demand a more nuanced question: "Will the price make its move—upward, downward, or sideways—before the contract's expiration date?"

Futures vs. Options


Despite their notable distinctions, futures and options contracts share certain commonalities. These similarities contribute to their appeal and functionality in the world of finance:


  1. Derivative Nature: Both futures and options contracts are categorized as derivatives. They enable investors to engage in trading activities related to an underlying asset without the necessity of owning the asset itself. This convenience allows traders to gain exposure to cryptocurrencies without the complexities of acquisition and storage.


  1. Hedging Capability: Futures and options contracts serve as valuable tools for risk management, offering crypto investors a means of hedging against potential financial losses. Hedging involves opening offsetting positions to mitigate risk effectively.


  1. Leverage Advantages: Both futures and options contracts provide traders with the opportunity to leverage their positions. Leveraged contracts empower traders to access the underlying asset with a smaller capital outlay, enabling them to trade larger contract sizes with limited funds. However, it's crucial to acknowledge that leveraging also amplifies potential risks.



Despite these shared attributes, futures and options contracts diverge fundamentally in several key aspects:


  1. Obligation Levels: A paramount distinction is the level of obligation associated with each contract. Futures contracts represent legally binding agreements that mandate the execution of the trade at the prearranged price and date. Conversely, options contract holders possess the right but not the obligation to buy or sell, allowing them to opt out of executing the contract if market conditions are unfavorable.


  1. Risk Profiles: The risk profiles of futures and options contracts differ significantly. Futures contract holders may face the prospect of liquidation if their wallet balance falls below the margin requirements of their open position. In contrast, options contracts, when purchased, carry limited risk. Buyers have the right to purchase the underlying asset but are not compelled to do so. Consequently, the risk for an options contract holder is typically confined to the premium they initially paid, regardless of subsequent price movements in the underlying asset.


  1. Fee Structures: The fee structures associated with futures and options contracts exhibit disparities. Options buyers are required to remunerate a premium to the seller, essentially a fee securing the right to purchase the underlying asset at a predetermined price on or before a specified date. In contrast, opening a futures contract does not necessitate an upfront fee. However, exchanges may impose various fees, including trading fees and funding rates, during the course of the contract.


Choosing Between Futures and Options Trading

The decision between engaging in futures or options trading hinges on various factors, including your risk tolerance, trading experience, and investment goals.


Risk Tolerance:


  • Futures Contracts: These entail a commitment to purchase the underlying asset and carry the potential for higher liquidation risks compared to options contracts. Buying options limits your risk, but selling them exposes you to unlimited risks.


Trading Experience:


  • Both Futures and Options: These instruments are better suited for seasoned traders who possess a thorough grasp of profit and loss dynamics, margin requirements, and associated risks. To effectively utilize options, understanding their characteristics and risks is crucial for constructing intricate strategies with limited risk. Trading futures necessitates market expertise and a robust risk management strategy.


Investment Objectives:


  • Futures Contracts: Offer an intuitive means to swiftly engage in leveraged long and short positions, capitalizing on short-term market oscillations. Both futures and options enable the amplification of returns, along with corresponding risks. Options, however, are commonly employed for more complex strategies that factor in market volatility. They also serve as tools for hedging against market volatility and managing portfolio risk.


Are Futures Superior to Options?

The superiority of futures over options hinges on your specific financial objectives. If simplicity is your goal, futures may be preferable, while those seeking flexibility may find options more appealing.

Which Is Safer: Futures or Options?

Both futures and options carry inherent risks. The primary distinction lies in the level of risk associated with buying or selling these instruments. With futures, substantial risk is involved in both buying and selling. In contrast, options buyers have their risk capped at the premium paid.


Both futures and options contracts possess distinct utilities and advantages. The choice between them should be guided by an assessment of your risk tolerance, trading expertise, and investment aims. Before venturing into trading these financial instruments, it's imperative to comprehend the associated risks and formulate a robust risk management strategy. By taking these factors into account and seeking professional guidance, you can make informed decisions and identify the financial instrument best aligned with your requirements.


Disclaimer: This article is intended for informational and educational purposes only. Investors should seek professional advice before engaging in trading or investment activities. Conduct your own research and due diligence regarding all trading instruments.


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