Options and perpetual futures provide traders with unique benefits compared to basic spot trading, which has led to their increasing popularity on both centralized and decentralized trading platforms. While options have less inherent risk (albeit still a risky product), perps are more cost effective. While this guide will not explore in depth strategies into either perpetual swaps (perps) or options, Chapter 3 of the Lyra Learn blog series will evaluate the advantages and disadvantages of both and provide some high-level examples of when a trader may choose one instrument over the other.
This blog will cover:
- What are derivatives?
- What are perpetual swaps?
- Advantages and disadvantages of perps
- What are options?
- Advantages and disadvantages of options
What are derivatives?
Derivatives are a type of financial contract that derives its value from an underlying asset, group of assets or benchmark. Derivatives are typically a leveraged instrument which increases their potential for risk and reward. Derivatives are useful tools to hedge a position, speculate on directional movements or give leverage to holdings. The derivatives market is one of the largest financial markets in the world and continues to grow. The most common types of derivatives are futures, forwards, swaps and options.
If you were to trade on a spot exchange in DeFi, i.e. Uniswap, you can purchase actual bitcoin with your funds at a specific exchange rate. This immediately transfers Bitcoin into your possession which you can hold for however long and to whatever price you like. Derivatives, on the other hand, allow you to trade without actually owning the underlying asset, you’re instead buying a contract which is designed to track the value of an underlying asset. This means that as the value of Bitcoin rises or drops, so does the value of the contract. In this way, you are able to benefit from the price movements of Bitcoin without actually ever having to buy or sell Bitcoin. According to the Token Insight 2021 Crypto Trading Industry Annual Review, the derivatives market had $63T of volume, which is significantly higher than spot trading at $49T.
But why would you want to trade derivatives? There are a few key reasons:
- Derivatives markets are highly liquid (the most trading volume), compared to any other market in the world
- Crypto derivatives allow you to short the market. In a short position, traders make money when the price of the asset falls.
- You can open positions larger than the amount of collateral you have when entering a trade on a derivatives market. Derivatives are created in the form of contracts that allow you to speculate on the price of a crypto-asset without owning it. This means the contract can be cheaper than the asset price.
More specifically, a perpetual contract is like a futures contract that has no expiry date. Futures are a derivative product through which buyers and sellers agree to trade at a pre-established price and date. Perpetual contracts, also known as perpetual futures, replicate a futures-like payoff without the expiration date, meaning that traders can now hold this perpetually without the need to roll-over the contract. Unlike options, futures do not require an immediate cash outlay other than what is required by a broker or exchange for margin. Perpetuals allow traders to make directional bets either long or short, with a significant amount of leverage. The flexibility and simplicity of these contracts has led to perps becoming one of the most popular products in all of crypto.
First introduced by BitMEX in 2016, traders can now access perps on a number of centralized exchanges such as FTX, Bitforex, Kraken Futures, Binance and more. In 2021, we saw perps find product market fit in DeFi with the rise of protocols like Perpetual Protocol, dYdX and GMX accessing the scalability of Layer 2 and Alt-L1 chains to offer an improved trading experience. As of today, over $125b is traded daily in the perpetuals market, making it the largest market.
The following is an excerpt from Perpetual Protocol’s learn blog: What’s a Perpetual Contract?
As we’ve established, a perpetual contract is a derivative, its price isn’t always the same as the underlying asset. As an example, during a bull market, the price of a BTC perpetual contract is usually higher than the price of BTC on the spot market, because people tend to be more bullish and expect the price to keep going up.
To reduce the price discrepancy between the perpetual market and the spot market, derivative exchanges in this space adopt a mechanism called “funding payments”. The way funding payments work is, there are automatic payments between traders at fixed intervals (e.g. every hour, or every 8 hours), where the traders on the more popular side (the long side during a bull market) will pay the less popular side (the short side during a bull market). By doing this, people will be incentivized to open a position with the less popular side, hence driving the price toward the spot price.
For instance, if 1 ETH perpetual contract is traded at 2,000 USD on a perpetual market (this price is known as the “mark price”) while 1 ETH on average is traded at 1,900 USD across the spot markets on multiple exchanges (this price is known as the “index price”), that means there is an excessive amount of longs on the perpetual market. To bring the two prices in line, at a fixed interval, the long holders will pay a funding payment to short holders. The greater the price discrepancy, the higher the funding rates will be, which results in a bigger funding payment. Note that funding payments are calculated by multiplying the USD value of a position by the funding rate.
Benefits and challenges of Perps
The perpetuals market, particularly in DeFi, is significantly larger with more depth than the options market at this stage. As such, perp markets are typically more liquid and easily accessible than options, meaning that trades are more likely to settle faster, with less price impact.
- Cost effective
Leveraged perpetual contracts typically have a low capital requirement. This means that in a highly volatile market like crypto, retail traders can gain access to a large amount of leverage to speculate and trade price movements, potentially receiving outsized returns for the amount of capital deployed (some perpetual contracts support up to 150x leverage).
- Time resistant
Unlike vanilla futures and crypto options which have a set expiry date, perpetual swaps have no end date, and the trader can hold the position for as long as they like without needing to roll the contract.
- Funding payments
While in theory you could stand to gain from receiving funding rate payments, generally speaking, the funding rate mechanics work against popular trades. If you are trading with the market consensus, you will likely be paying a funding rate to shorts on the other side of the trade lowering returns.
- Uncapped downside / Liquidation
While leverage trading could increase your profits, it is also risky because small market movements could liquidate your assets. Also, if the market gaps, you could suffer significant losses. Gapping means that the market price drops or increases without the trader having the chance to trade.
Options are a tool that allow you to trade the future value of a market. Options are a derivative of an underlying instrument that gives you the right but not the obligation to make a trade at a set price, at a set date in the future. There are two kinds of options, calls and puts. Calls allow the holder to lock in a price at which to buy the stock. Puts allow the holder to lock in the selling price. You buy calls when you think the token will go up, and you buy puts when you think it’ll go down. Options don’t last forever, though, they have an expiration date. After this date, the holder can no longer buy or sell the asset at the strike price and the option is worthless.
In recent years savvy traders have flocked to options markets on centralized cryptocurrency exchanges, predominantly Deribit (over 90% of crypto options volume) along with other exchanges like Okx, CME, LedgerX and FTX. A breakdown of the options volume by exchange can be seen in the chart below from a recent report from The Block crypto.
Unlike Perps, options trading has yet to find any real traction on-chain besides earning yield with Decentralized Options Vaults (DOVs). This is due to a number of reasons, from low liquidity because of impermanent loss for liquidity providers, extreme ‘blow up’ risk, and low liquidity, all of which lead to undesirable pricing. To understand how Lyra solves these problems, head to the whitepaper. For more information about options, head to Chapter 1: Crypto Options Basics.
Benefits and Challenges of Options
- Limited downside
As an option buyer, what you need to pay upfront is called “the premium,” which will be the maximum amount of money you can lose if you don’t exercise your right in the future.
- Flexibility of payoff structure
Options are versatile tools that allow traders to construct creative and complex payoff structures to benefit in bull, bear, or even crab markets. Traders can take advantage of multi-leg positions like spreads, strangles and flies to execute calculated strategies to speculate on price movements and volatility without being overexposed. For more about complex strategies read here.
- Execution choices
An options contract gives the trader the right on the buyer and not an obligation to buy or sell an underlying asset. This means that a buyer only needs to buy/sell the underlying asset when it’s most profitable to do so. Such an advantage doesn’t exist with futures contracts.
- No custody of the underlying asset
As an options trader you’re purchasing a contract or promise to an asset at a specified time in the future, meaning the right is just data stored on the exchange’s server, there is no custodial risk for the underlying asset (but you still need to post some assets as the margin, which is still subject to custodial risk).
Options are a versatile instrument, but they can also become complicated. It is important to understand all elements of options risk (the greeks) while managing macro market risk, which affects the price of the asset. When trading options in either direction, it is also important to factor in how volatile a market is and when this volatility will occur.
Unlike perpetuals, options have an expiration date where a closing trade needs to be executed or the option simply expires worthless. However, on exchanges like Lyra and Deribit, options can be bought and sold before expiration, allowing more flexibility for traders.
Spoiler: there is no winner. Both Perps and Options have their own advantages in specific situations and it is ultimately up to the trader to decide which is best for any particular situation or market conditions. The mutual existence of futures and options markets in mature traditional markets (worth trillions of dollars each) shows the necessity for both futures style and options products in DeFi.
Huge shout out to the Perpetual Protocol team for your assistance with this article.
Lyra is an open protocol for trading options built on Ethereum. Lyra allows traders to buy and sell options that are accurately priced with the first market-based, skew adjusted pricing model. Lyra also quantifies the risks incurred by liquidity providers and actively hedges them, encouraging more liquidity to enter the protocol.
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