Futures and options are both derivatives that investors can use for trading or hedging current investments. These financial products allow investors to buy or sell an asset at a specific price and date, protecting them from further price fluctuations. However, these instruments are quite different in how they work and what risk they bring to investors.
Futures
A futures contract is the obligation to buy or sell an asset at a specific price and date. The futures contract also specifies the number of units of the underlying asset that will be bought or sold. The asset settlement occurs when the contract reaches its expiration date. And whoever owns the futures contract at the expiration date they must buy or sell the asset at the agreed price.
There are two major ways how the underlying asset can be settled according to a futures contract: physical delivery or cash settlement. Cash settlement doesn’t involve the direct transfer of underlying assets.
How to use futures contracts?
The most obvious one is holding the futures contract until its expiration. This is one of the ways to hedge investments from price volatility because you can receive an asset or its equivalent at the agreed spot price.
But many traders like to buy and sell futures contracts on the market before their expiration. And in this case, they can either wait for the expiration date and follow contract specifications or make two other actions: offset and rollover.
Offsetting refers to closing a position by creating opposite of equal value and size. This allows traders to realize profits or losses without taking physical delivery or cash settlement. For example, if you have two short (sell) contracts for Bitcoin that expire next month, you can buy two contracts of the same size expiring at the same date. The difference in price between the initial position and offset position will represent a trader’s loss or profit.
A rollover means “prolonging” or extending position before contract expiration. The trader who is going to roll over their futures contracts may choose to switch to another contact with another date. To do so, they first offset their position and then open a new position with the futures contacts of the same size but with another expiration date. For example, you have a long BTC futures contract expiring in October, so you can sell a futures contract with an expiration date in September and a buy futures contract with the same size but an expiration date in November or even further.
There is also a specific futures type called perpetual futures. This futures type doesn’t have an expiration date, so they can be held indefinitely without the need to roll over contracts.
Futures trading example
Let’s say you want to buy a futures contract with physical delivery on Bitcoin next month. You choose a futures contract with 1 BTC as its underlying asset. This means you will be obligated to pay the seller for 1 BTC on the delivery date.
As the price of Bitcoin goes up and down, the amount of gain and loss is credited or debited to your account at the end of each trading day. So you should have some funds on your account to cover possible price fluctuations. If the spot market price drops below or rises above the contract price you agreed to pay, you still need to pay the seller at the agreed price on the delivery date. Depending on that, you may receive a profit or loss that represents the difference between the agreed and market price.
If you lose interest in accepting Bitcoin from the seller, you can sell your contract before the delivery date or roll over to a new futures contract.
Options
Options give investors the right but not the obligation to buy or sell an asset. It means if investors decide not to do so, they can refuse to buy or sell an asset at a specific price upon reaching the expiration date. Options do not represent the actual ownership of the underlying asset until you use the right to buy or sell an asset.
To get the right to buy or sell an asset, investors pay a so-called premium. The premium amount usually depends on the strike price — the price at which you can buy or sell an asset until the option’s expiration date. The date indicates the day when the contract must be used.
Call and Put options explained
There are only two types of options: call and put. A call option offers you to buy an asset at the strike price, while a put option allows you to sell an asset at a predetermined price.
Example:
Let’s say you open a call option to buy Bitcoin at a $45,000 strike price and pay a $1,000 premium to use this right next month. The current spot BTC price is $43,000. Assume the BTC spot price jumps to $50,000 when your option has an expiration date. In this case, you can use your right and buy BTC at $45,000. After that, you can immediately sell your Bitcoin at the current market price of $50,000 and get $4,000 profit ($50,000 – $45,000 – premium ($1,000)).
Let’s imagine another scenario with the same inputs. The BTC price reached $44,000 at your call option expiration date. It means your option is worthless but you don’t have to use your right to buy Bitcoin at $45,000. You can just buy Bitcoin at the current market price if you want. So you just paid $1,000 for the right that you haven’t used and it’s your max loss in this deal.
The same works for put options and selling the asset. If you have the right to sell the asset above the market and the price difference is bigger than your premium, then you can profit from this trade. Otherwise, you just pay a premium for nothing.
For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
