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Options and futures: Good, bad, necessary?

Jan 15, 2021
Options futures trading

Independently of whether they are bonds, stocks, cryptocurrencies or any other asset class, the need for various functionalities comes with the advent of every new tradable asset. Supplying the market with what we consider are necessities for efficient (strong) markets is paramount for long lasting assets and successful exchanges. Following our introduction on exchange functionalities [1] and offerings like margin trading [2] in the digital assets space, we will now dive into similar services: options and futures. 

Brief description of options and futures 

Even though options and futures contracts are both different types of derivatives, they don’t share many more similarities besides that. The key difference lies in the rights and obligations of the contract holders. While futures obligate each party to buy or sell, options give the holder a right (not an obligation). In futures trading, the buyer agrees to buy an asset at a specified price at a specified date [3]. In an options agreement, there is a writer, the person who is selling the right, and a holder, the person buying the right. The holder is buying the right to buy or sell an asset at a specified price, on or before a specified date. The holder has no obligation to exercise this contract, but the writer has an obligation to the holder. Naturally, the exercise of the option will depend on the exercise price and current underlying price. It is said to be “in the money” if the underlying price is higher than the exercise price for call options and viceversa for put options.

The most common types of derivatives include futures, forwards and options, which are based on a variety of assets, including stocks, currencies, bonds and commodities [4]. Given the sheer number of derivatives available today, the market’s size is difficult to ascertain. Statista has compiled a 9 year summary, starting with 12.13 billion futures contracts and 9.42 billion options contracts in 2013 to over 19.24 and 15.23 billion respectively, with a notional value amounting to over US$ 495 trillion in OTC deals by June 2020 alone. [5][6]

History, types and actors

Originally, futures markets were established to reduce risk and manage cash flows among commodity companies. Getting commitments for their produce ahead of time at a pre-arranged price provided a layer of safety to an already volatile industry. Farm output, for example, can take time in preparation and can incur many risks such as production risk (weather and climate), market, institutional, personal and financial risk [7]. Therefore, it makes sense for commodity companies to want to avoid market price fluctuations and uncertainties in the future. (One could make a similar initial case for cryptocurrency miners, trying to secure a base price on their efforts). While traditional markets have been using various forms of derivatives for a long time, their modern varieties can be traced back to the 1970s and 1980s, when the Chicago Mercantile Exchange and Chicago Board of Trade introduced futures contracts [8].  

Exchanges with a derivatives platform that have the option of entering into futures, contracts and/or options are more likely to mainly attract experienced traders looking for various ways of playing the market and hedging positions. 

Benefits and disadvantages to cryptocurrency options and futures contracts

  • Tailored exposure. Futures allow investors to gain exposure without having to hold the underlying cryptocurrency. Futures allow investors to speculate on the future price of an asset. 
  • Custody. Because holding future contracts doesn’t mean holding the underlying cryptocurrency, custody efforts are not a necessity.
  • Leveraged positions. Similarly to margin trading, futures and options provide the possibility of leveraging positions and thus magnifying gains (and losses), with lower restraints from available funds. Margin calls are still applicable for futures, but not so for options trading.
  • Liquidity. There are many futures markets that are liquid, at times even more than their underlying equivalent selves. For instance, the futures market in U.S. Treasury bonds is regarded as being much more liquid than its cash market. In some cases, the futures market becomes the industry benchmark. For example, commodities like gold, crude oil and cotton futures prices form the basis for pricing other related products in the industry. On the other hand, some futures markets are thin, meaning not very liquid. In the case of digital assets, futures markets are several times bigger than their spot counterparts.
  • Volatility. Although some knowledgeable individuals may assume an inverse relationship between cryptocurrency futures trading and volatility (as futures trading commences, digital asset volatility decreases), the truth is that there is no academic consensus in this regard [9][10]. 
  • Price discovery. Some results drawn on the intraday prices show that futures are leading the price discovery at different frequencies even with comparably low trading volumes. [11][12]

Note on valuation: Usually, the valuation process for options is far from being a straightforward one. Several inputs are part of the basic valuation model (Black-Scholes-Merton for European options, for example) to determine its fair price, including underlying volatility, underlying price, strike price of option, risk free rate and the time to expiration. In options contracts, the option right is sold and collected as a premium over the total notional value. In contrast, futures contracts don’t require early premium paid, even though its valuation takes into account a risk-premium when arbitrage approaches are used.

All-in-one SCALABLE

Added exchange functionalities like margin trading and futures and options should not be underestimated only because they can be perceived as “common.” Having robust technology to support the frequent bigger-than-spot markets is of the utmost importance for both exchanges and users, and we take pride in counting with the best out there. Get in touch to find out more about our white label exchange functionalities. 

 

 

References

[1] “Digital Asset Exchange: Main Functionalities.” Resources, Scalable Solutions, 7 Dec. 2020, scalablesolutions.io/news/digital-asset-exchange-main-functionalities/

[2] “Margin Trading and Why Do We Need It.” Resources, Scalable Solutions, 14 Jan. 2021, https://scalablesolutions.io/news/margin-trading-and-why-do-we-need-it/

[3] Nowadays, “perpetual” futures have come to existence. These vehicles are now the most traded ones, having a volume traded up to 7 times of its closest fixed date counterpart. They have no expiry date, and usually have higher (funding) costs.

[4] The most actively traded futures contracts are stock index futures. They carry liquidity, leverage and tax advantages over trading index ETFs. These are highly active because of how much money is managed in the stock market. Portfolio managers routinely use futures to hedge their exposure.

[5] “Global Futures and Options Volume 2013-2019.” Statista, Statista Research Department, 23 Nov. 2020, www.statista.com/statistics/377025/global-futures-and-options-volume/

[6] “OTC Derivatives Statistics at End-June 2020.” The Bank for International Settlements, 9 Nov. 2020, www.bis.org/publ/otc_hy2011.htm#:~:text=The%20increase%20primarily%20reflected%20interest,attributable%20to%20a%20seasonal%20pattern.&text=The%20notional%20amounts%20of%20other,flat%20over%20the%20same%20period

[7] Komarek, A. M., De Pinto, A., & Smith, V. H. (2020). A review of types of risks in agriculture: What we know and what we need to know. Agricultural Systems, 178, 102738.

[8] “Futures Exchange.” Wikipedia, Wikimedia Foundation, 13 Dec. 2020, en.wikipedia.org/wiki/Futures_exchange#History. 

[9] Corbet, S., Lucey, B., Peat, M., & Vigne, S. (2018). Bitcoin Futures—What use are they?. Economics Letters, 172, 23-27.

[10] Kim, W., Lee, J., & Kang, K. (2020). The effects of the introduction of Bitcoin futures on the volatility of Bitcoin returns. Finance Research Letters, 33, 101204.

[11] Fassas, A. P., Papadamou, S., & Koulis, A. (2020). Price discovery in bitcoin futures. Research in International Business and Finance, 52, 101116.

[12] Kapar, B., & Olmo, J. (2019). An analysis of price discovery between Bitcoin futures and spot markets. Economics Letters, 174, 62-64.

Sources

Hale, G., Krishnamurthy, A., Kudlyak, M., & Shultz, P. (2018). How futures trading changed bitcoin prices. FRBSF Economic Letter, 12, 1-5.

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