Crypto Futures Contracts, Options, Perpetual Contracts Explained
What are crypto futures?
Cryptocurrency futures are contracts between two investors that bet on a cryptocurrency’s future price. They allow investors to gain exposure to selected cryptocurrencies without purchasing them. One unique feature of futures that differentiates futures from other derivatives is the settlement date.
Let’s walk through an example of going “long” and “short” in crypto.
You are purchasing a futures contract. First of all, you need to choose a settlement date. Different exchanges offer different options ranging from weekly, bi-weekly, quarterly, etc. Suppose you want to buy a bi-weekly contract. If the underlying crypto A worth $7,000, and opening a position requires $3,500. You want to open a position worth 0.5 crypto A and one contract worth 1$, then you need to buy 3500 contracts to open a position worth 0.5 cryptos A = $ 3500. The exchange directly matches you with an opposite investor when you open a position. If you go “long” with your position (you bet on crypto A price increase in the future date), then you will be matched with one who went “short” (betting on the price decline on the future date). After two weeks, the contract will be settled. If you choose to go long, and the crypto A price has declined, you pay your counterpart; if it went adverse, then vice versa.
What are Crypto Options?
Crypto options are similar to the futures we mentioned above, but some details need to be changed. With crypto options, the trader does not go “long” or “short”; instead, they have to “call” or “put” options. “call” means to purchase the crypto at an agreed price till the contract expiration date. Conversely, a “put” option gives the trader the right to sell at an agreed price till the contract expiration date. With either option, it’s entirely up to the owner to execute their commands or not.
Let’s walk through an example.
If you purchased a “call” option for crypto A at $7,000 that expires in two weeks, this means, regardless of where the price is at, you have the opportunity to buy one BTC for $10,000 (it’s called the strike price, meaning you could buy at this price in the future date). If the price of crypto A has risen to $8,000, you could execute your “call” option to buy the agreed “$7,000” to gain a $1,000 profit. If the price drops to $6,000, you can let the “call” expire and not buy the crypto.
The above trading method sounds like a risk-free approach to crypto; however, it’s not. Each option has its price called a premium, which you need to pay when buying crypto. When the trader lets their option expire, they still lose the premium.
What are perpetual contracts in crypto?
One feature differentiating perpetual contracts from other futures or options is that perpetual contracts don’t have an expiration date. Traders can keep their positions open for as long as they want under certain conditions. Another significant part is that traders must have a minimum amount of crypto as a margin for the perpetual contract. Due to the time limit, the contract price is always in line with the underlying asset in the futures contract. But the perpetual contract does not have an expiration date, so that the contract price might deviate significantly from the underlying asset. So there is a funding rate, which helps tether the contract price to the underlying asset. The funding rate payment doesn’t run to exchange; it goes from one trader’s side to the other.
Let’s walk through the perpetual contract.
Suppose one perpetual contract for crypto A costs $1 and opening a position needs $500, and crypto A worth $1000, then you could purchase 500 perpetual contracts to open a position to purchase 0.5 cryptos A. You could wait for days, weeks, or even months to close your position. The exchange will pay you the difference when you close the position according to the entry price and current market price. This payment is originally from another player who chose short and lost money. However, there would be funding payments and additional exchange fees you need to pay.
Leverage is also considered one of the derivatives in crypto. In the former article, we addressed leverage and how it works? The reader may click the link here to deep dive into the article and deepen their understanding of leverage trading.
In conclusion, as we always assert, before investing in the crypto, please read and do your research on the crypto you will invest in and invest in something you could afford to lose; never let risk override your financial stability.
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