There are many ways to generate income by investing. When investors are beginning in the market, they are limited to directly purchasing the asset in question and creating short or long positions.
However, it is also possible to generate income from the asset without directly investing in them. These types of investment alternatives are called derivatives. In this article, the reader is going to learn about different types of derivatives and focus on understanding various aspects of Crypto Options and Futures.
What are Crypto Derivatives?
Crypto derivatives are investment products that do not require direct investing in a particular asset class. When dealing with derivatives, the investors do not have to hold the underlying asset, which is a specified cryptocurrency in this instance.
Investors may deal with a given cryptocurrency by projecting their prices based on technical or fundamental analysis. The two main types of Crypto Derivatives are Futures and Options.
Both these derivatives are a type of financial contract where investors are required to predict the price movement for the crypto under the question to make profits. It is important to note that Crypto Futures and Crypto Options can also be divided into sub-types.
What are Crypto Options?
Crypto Options are a type of derivatives contract that allows the investors to predict the price of a given cryptocurrency in addition to a predetermined expiration date. It means when an investor purchases or sells a Crypto Option for Bitcoin, they do not directly purchase Bitcoin to make that option active.
A Crypto Option is like a financial contract, and it can include the terms of the profit or loss outcome. If a person believes that the price of a given cryptocurrency is going to reach a predicted level on a specific date, they can purchase an Option contract to the same effect.
If the prediction of the Options investors comes true, they will make profits, and if it does not materialize, they could suffer from losses.
Types of Crypto Options
The classifications for Crypto Options are given as under:
Call and Put Options
A Call Option is a type of derivative contract where the investors are allowed to purchase a given cryptocurrency before the completion of a specified duration. It means that when the market is bullish, Call options holders earn profits, and when the markets turn bearish, Call Options traders can suffer losses.
On the other hand, a Put Option is a contract where investors are allowed to sell a specified cryptocurrency before the expiration date arrives. It means that Put Options holders profit when the market is bearish, and they incur losses when the markets turn bullish.
For purchasing both Call and Put Options, the investors are required to pay a premium. The premium percentage depends on the remaining time, volatility, and current price.
American and European Options
The American Options are the type of financial contract where the holder is allowed to use it at any given time before the expiration date. Meanwhile, the European Options are those where the investors can redeem them only at the specified time, such as the last day of expiration.
Depending on the risk appetite and the command of market analysis, the investors must choose from both types of option styles.
Naked Crypto Options
Naked Crypto Options are high-risk derivatives bet. It entails producing an options contract without acquiring the underlying asset in advance by the issuer. For a Naked Call option of $4000 for XYZ token for 90 days, the investor is required to sell their XYZ token at $4000 regardless of the increase or decrease in prices.
If the market rises to $5000, the Call option holder would have to purchase XYZ token at a 33% premium and sell it to the Call Options holder incurring a loss of $1000.
When dealing with Naked Crypto Options, the brokers mandate the issuer of the option to commit a given amount as collateral, which is known as the option margin. This options margin the issuer must maintain until they sell the naked option.
How does a Crypto Option Work?
To understand how a Crypto Option works in practice it is best to use an example. For instance, if a cryptocurrency investor purchases an XYZ token call option at $4000, that is set to expire in 100 days at a premium of $500. It means that the holder of the call option is now eligible to purchase the XYZ token at any point for $4000 before 100 days limit expires.
In the spot market, if the price of XYZ token increases to $6000, the holder of the option can purchase the token for $4000 at the cost of a $500 premium. The total profit of the XYZ call options holder is going to be $2000 minus the premium of $500.
On the other hand, if the price of XYZ tokens in the main markets drops to $2000, the Option holder can suffer from a loss of the $500 premium. However, with an Option contract, the investor is not obligated to purchase the XYZ token by suffering a loss of $2000.
Therefore, the investor is only going to suffer from the loss of the premium amount that they have paid to acquire the Call Option. Another scenario is when the investor purchases a Put Option for XYZ token at a premium of $500 with 100 days limit. This time the Put option allows them to sell XYZ tokens for $4000 before the expiration date.
If the price of the XYZ token increases to $6000, the Put Options holder could choose not to sell their XYZ tokens. If they do, it means that they would have to suffer from a loss of $2000 in their sales. Under such circumstances, they would have to suffer from the loss of their Put option premium of $500 only.
However, if the price of the XYZ token falls to $2000 in the main markets, the Put Option holder will be able to sell their XYZ tokens for $4000, and their total profit of $2000 will be subtracted from the Options premium of $500.
How to Sell a Crypto Option?
Thus far, the investors have learned about Call and Put Options. However, an individual trader can generate an Options contract. The issuer of the Options contract is known as the Options writer. They can collect the premium from the buyers of Options from them.
To generate a new options contract, the issuer or Options writer must commit a specified amount of cryptocurrency reserves from their portfolio. In this manner, they would be able to use these crypto reserves in case of adverse market development.
In the cases where an options writer sells the options contract, it is called an uncovered or naked option. As mentioned before, naked options carry higher risks in comparison to the regular options that already carry considerable risk percentages.
What are Crypto Futures?
Crypto Futures are also derivatives contract that entails purchasing or selling a given cryptocurrency for a specified price and a given duration. Futures contracts were created to balance the volatility in the prices of agricultural products and encourage farmers to acquire seeds in advance for a specified price.
Futures are created for a set of asset classes, such as commodities, stocks, and cryptocurrencies, just like options. However, options allow investors to use options without having to use them in case of a loss.
For Futures Contracts, the investors are under obligation to carry out the futures contract regardless of loss or profits. Therefore, Futures trading is riskier in comparison to Options.
Working of Crypto Futures
Investors can buy or sell a futures contract. When they sell a futures contract, it means that they are under obligation to sell a given cryptocurrency for a predetermined price on a specified date.
In this manner, when the expiration date has been completed, the person who has purchased the futures contract from the seller is liable to purchase the underlying asset from them at a specified price regardless of the market movement. The seller makes a profit when the market is bearish and generates income when the market creates losses.
On the other hand, when a person purchases a futures contract, they essentially lock a set price in advance. In this instance, the buyer is under obligation to purchase a given cryptocurrency at the set price before expiration, regardless of the market movement.
They can make a profit when the market goes up and suffer from losses if the market goes down from the set price. Another important aspect of a futures contract is that it does not require the investor to stake the whole value of their contract.
They can hold some percentage of the total value of the Futures contract to fulfill it, and it is called trading on margin.
Under such circumstances, if the underlying cryptocurrency drops in value, the issuer of the futures contract or exchange can issue a margin call. When a futures contract holder receives a margin call, they have to submit more money to balance their collateral or deal with the lapse of the futures contract.
For Options, the investors are under obligation to pay premiums, but with Futures; there is not any obligation to pay any premium amount.
Types of Crypto Futures
One important type of futures contract that is specific to the cryptocurrency market is called Perpetual Contacts. Perpetual Contracts are a type of financial contract that is popular among Day Traders. They are like ordinary futures contracts with the difference that the investors can hold them for an indefinite period.
In simple words, it means that the Perpetual Contracts do not have an expiration date. However, the futures owner has to keep paying to renew the contract at regular intervals. This payment is called the funding rate. The sellers of the futures contract pay the funding rate for the entire duration they wish to hold the perpetual contract.
At the same time, they must also maintain a specified value in a committed account known as a margin to keep the Perpetual Contract active.
How to Use Crypto Futures?
Take, for example, a futures contract for XYZ token that is currently fairing at $4000 in the market. The investors, who believe that the price of XYZ token is going to rise, can purchase the futures contract at $4000. It means that when the market rises to $6000 or other higher amounts, the $4000 futures holder will be able to purchase XYZ tokens for only $4000.
On the other hand, if the price of the XYZ token tank to $3000, the futures buyer will have to acquire the XYZ token at a loss of $1000 before the expiration date is over.
Similarities Between Crypto Options and Futures
Here are some of the most noteworthy similarities between Options and Futures contracts for cryptocurrencies:
Both options and futures are classified under the head of derivatives contracts. In this manner, the dealers of the futures and options do not need to invest directly in underlying assets. Both of these contracts are about predicting the price of a given cryptocurrency in later days, and both contain an expiration date except perpetual contracts.
Both Futures and Options can be used as hedging positions. Hedging is a type of trading technique that is used to minimize trading risks by creating offsetting positions. For example, an investor can offset their long crypto position by offsetting it with a put option for the same cryptocurrency.
On the other hand, an investor can use a futures contract to lock a specified price for a cryptocurrency in later days and hedge against market volatility. The investors should keep track of the ideal Strike price, which is the purchase or sell amount as per an options contract.
With both Futures and Options, investors can generate leveraged positions. The futures or options investors, in this manner, can gain exposure to a price of a given cryptocurrency for a fraction of incurred costs. In other words, the investors may purchase a massive amount of cryptocurrencies with small capital.
However, the investors have to manage the collateral amount and calculate the trading margin at all times. Therefore, it is important to keep in mind that leveraged trading with futures and contracts is the riskiest investment strategy.
Differences Between Crypto Futures and Options
Here are some of the key differences between Futures and Options contracts:
Obligations and Requirements
With Futures, the investors are bound to carry out the sales or purchase of the underlying asset as a mandatory obligation. It means that even if the market movement has gone in favor of the holders of the future, they still have to carry out the trade and incur losses.
On the contrary, the Options holders are at liberty to not carry out the required sales or purchase of the underlying asset at their discretion. It means that they may not redeem the options contract in case of unfavorable market movement.
The investment costs for Futures contracts are often smaller in comparison to that of the options. The Futures traders can open or close a new position without having to pay any advanced fees.
However, the futures dealers have to pay other expenses such as commission, trading fees, and funding rates that are unique to different crypto derivatives exchanges.
In contrast, the investors who are purchasing options contracts can do so by paying a fee called the premium. In case of negative market development, the options holders can end up losing their options premiums but refrain from incurring bigger losses.
Time Decay is the depreciation of the Options contract value. As mentioned before, the options traders must pay a premium upfront.
However, as the expiration date for options contracts draws near, the premium can contract. On the other hand, the passage of time does not have any tradable impact on Futures.
The risk potential of Options is smaller in comparison to the futures contracts. The options traders can stop their loss at the cost of losing their premium amount in case of a negative market movement.
However, futures contract holders must fulfill the contract regardless of unfavorable market conditions. Meanwhile, futures contracts are also prone to liquidation risks for leveraged positions where the investor can suffer from depleting collateral value.
Options and Futures for cryptocurrencies are a diversifying trading method. Investors who are well-versed in the market dynamics and have gained enough market experience may be able to use these derivatives to their advantage.
However, it is important to understand that both options and futures contracts carry a considerable amount of risk and require a firm grip on the market analysis. Therefore, cryptocurrency investors should learn about them and perform in-depth research on the matter before working with derivatives crypto exchanges.