Options vs Perps: A Short Story

This article is the first of many to come. Expect the unexpected – actually useful content brought to you by a real DeFi protocol in partnership with an industry professional. A short story!

Options and perps are financial contracts with widely different properties. Thus, they come with inherent tradeoffs – both have various strengths and weaknesses, allowing them to fit into different strategies and portfolios.

All contracts don’t come equal. In this ‘short’ story co-authored by two consiglieres of the Premia Mafia, we talk about the practical implications of using one instrument over the other. A medium-level overview of both, accompanied by actionable examples and instructions.

The alpha is indeed free on Mondays – and in this case, any day of the week. With this new age of quality content, we hope to provide our community with an opportunity to learn concepts both new and old.

Now take a seat in your Aeron, get caffeinated, pop a Zyn, whatever it is you kids do nowadays. You asked for it, now it’s here. Time to put in the effort bros.

Please note that Premia does not provide investment advice, and nothing herein should be construed as such. Anyone considering trading or holding derivatives or crypto assets should be aware that the risk of loss can be very high, and it is upon each individual to seek advice from an appropriate professional advisor.

Before delving into this article, we recommend completing the Options 101 and Greeks courses inside the Premia Academy unless you’re already familiar with these topics.

Options vs Perps: A Prelude

Before taking in our personal opinions, examine the following facts for added context. Here are some notable stats from May 13th regarding the usage of different derivatives in the crypto markets.

As is apparent, perps are king in crypto. But why?

It’s a classic example of monkey see monkey do… quick PnL swings and easy management. Compare this to traditional markets, where options dominate in terms of notional volume traded. This is mostly due to their versatility and risk management capabilities — however, there’s also the caveat of most altcoins not having liquid options markets.

Options are a relatively new phenom in crypto, but are rapidly gaining popularity. As options become available on spot ETFs, we expect their trading volumes to increase significantly, mirroring the prominence of options in traditional finance.

On the retail side of things, just because everyone else is a perps one-trick-pony doesn’t mean you have to be. There’s a time and place for every instrument; the trade you’re making should dictate what tools you use. When there’s free money on the floor you don’t want to be limited by your skillset.

Now, let‘s quickly go over the big three — options, perps, and futures — before getting into the trenches.

What are Options, Perps, and Futures?

A major challenge for new traders is their general lack of knowledge. Simply put, new traders don’t fully understand the products they are trading. 

Beginners often underestimate the intricacies and risks, leading to poor trading decisions and potential losses. It’s crucial for traders to fully grasp how these products function, including their pricing, market behaviors, and specific risks, to make informed decisions and manage risks effectively.

So, for the newbies out there.. here’s a quick rundown;

What are Derivatives?

Derivatives are financial contracts that derive their value from an underlying asset, group of assets, or benchmark. They are typically a leveraged instrument, increasing their potential for risk and reward. 

The most common types of derivatives are futures, forwards, swaps, and options. Trading derivatives offer strategic benefits such as risk management, speculative opportunities, cost efficiency, and access to otherwise inaccessible markets, making them a versatile tool for sophisticated financial strategies.

What are Options?

Options are derivatives that give traders the right but not the obligation to trade an asset at a predetermined price at a date in the future. There are two types of options: calls (right to buy) and puts (right to sell). 

To learn more about options, we warmly recommend completing the Options 101 courses inside Premia Academy – it’s a great place to start. However, here’s a TL;DR:

Advantages:

• Limited downside

• Flexibility and customization of payoff structure

• Execution choices

• No custody of the underlying asset

Disadvantages:

• Complexity

• Expiration date

What are Perpetual Swaps?

Perpetual swaps, perps, or perpetual futures, are derivatives that allow you to buy or sell the value of an underlying asset. They are like futures contracts but have no expiry date, allowing traders to hold a position indefinitely without the need to roll over the contract. It enables traders to speculate on the price movements of an asset, like cryptocurrencies, using leverage. These contracts often involve a funding rate that adjusts based on market conditions to keep the swap price aligned with the underlying asset price.

Advantages

• High leverage

• Liquid

• No expiry

Disadvantages

• Funding payments

• Uncapped downside/liquidation (obviously, you should always use stops)

What are Dated Futures?

A dated future, or simply a futures contract, is a tradable contract that allows for buying or selling an asset at a predetermined price at a specified time in the future. These contracts are traded on exchanges and are used by investors to hedge against price changes, speculate on future prices, or manage exposure to various types of risk. Each contract has an expiration date, after which the contract must be settled by physical delivery or cash settlement.

Advantages

• Best for basis trading

• Liquid

• Shows insights to expected future price of an asset

Disadvantages

• Set expiry date

• Liquidation risk on leverage

Thoughts on Different Derivatives

Personally we use perps to hedge Deltas while trading options, offering the advantage of no expiration, liquidity, and ease of lowering our margin requirements while on portfolio margin. On the other hand, we use dated futures specifically for basis trading, allowing us to secure prices within precise timeframes. Both dated futures and perps are products we trade regularly depending on our needs to manage the portfolio.  

Now, let’s get into the practical use cases for both instruments – who uses them, what they are used for, and what makes them so useful for these specific applications. These concepts are essential to understand. In order to become the trading savant you were born to be, you need to put in some effort.

Marty’s Thoughts: Practically Speaking

Now that we’ve gone over the prerequisites… Let’s talk about the more blatant differences between these instruments along with some practical examples.

Even though perps have no expiration, funding can get very, very expensive. Funding and fees are the bane of your profits as a perps trader. In any sort of trading you should always try to avoid crossing the spread, and always use limit orders. In general, you should be doing everything in your power to prevent your monies from ending up with those nasty market-makers. 

When specifically employing longer term directional trades I prefer to use dated futures. With dated futures, you can hold the position until contract expiry without paying funding.

Let me give you the practical examples in the form of case studies; Time Horizons, and the under-exploited Cash and Carry. We’ll also discuss the Marty Classic further down.

Case Study: Time Horizons

Let's say it's January, a brand new year. You believe Bitcoin is going to trade higher by the end of the year. There are a few different ways to take the trade:

a) Long Perps:

• Advantage: No expiration date, allowing flexibility to hold a position as long as needed.

• Disadvantage: Can incur high funding fees, especially in bullish markets, which can diminish profits over time.

b) Long-Dated Futures:

• Advantage: Lock in a price now without having to pay the continuous funding fees associated with perps.

• Disadvantage: Subject to time decay as the expiration approaches, potentially losing value if the expected price increase does not move in your favor by expiry date.

c) Long Options:

• Advantage: Provides the right but not the obligation to buy at a set price, limiting losses to the premium paid. 

• Disadvantage: Premiums can be expensive, especially for at-the-money or in-the-money options, and the value erodes as the expiration date nears if the market does not move favorably.

For a multi-month hold type of play, using long options like buying a call or a call spread is probably the best choice. This method limits your downside to just the premium paid, while providing substantial upside potential.

On the other hand, long-dated futures are often a better choice than perpetual swaps for longer durations. With long-dated futures, you can secure a price now without incurring the continuous funding fees associated with perps, making it more cost-effective for expecting a gradual market rise. This choice avoids the potential erosion of profits due to the high funding costs that can accumulate with perpetual swaps over extended periods. However, the key downside with dated futures is that the asset must move in your favor before the expiry date, otherwise the position may result in a loss. This is because the dated futures price closes into spot price the closer it gets to expiry.

As you can see, the key comparison can be made in the specific time horizon of the trade… The longer the trade goes, the more you pay in funding. Comparatively, futures and options are subject to time decay as they approach maturity. Now, let’s look at a trade that often goes under the radar due to plain laziness; the basis trade.

Case Study: Cash and Carry

Situation: Bitcoin is currently trading $70,151 and ETH is currently trading $3,595. The current buzz in the cryptocurrency market is fueled by a mix of returning retail traders, anticipation of an ETH ETF, significant capital flows into Bitcoin ETFs, and the anticipation of a potential rate cut or cuts. This atmosphere has led to futures contracts trading at a notable premium relative to the spot markets. 

How long can it go up? Are there any strategies to lock profits now?…. Yes.

1. Buy spot

2. Short futures contracts

3. Hold position until expiry 

How much is there to be made?

The basis means the difference between the spot price and the futures price. The basis captured will be the total profit. Remember this must be held to expiry for max profit. Let's see how much juice there is below. We’ll use an imaginary exchange for this example. Basis fluctuates every second. On March 31st, the 3-month annualized basis hit 37.08%.

Considerations:

1. Trading Costs: Entry and exit costs are crucial in planning your trades. These include trading fees, which vary depending on the platform and the specifics of your trade, as well as potential slippage, which refers to the difference between the expected price of a trade and the price at which the trade is executed. These costs can affect the profitability of your trading strategy.

2. Execution Risk: Trading both Spot and Futures contracts simultaneously, especially in a volatile market, introduces execution risk. This risk is the possibility that your trades may not be executed at the desired prices, affecting the expected outcome of your strategy. Quick and significant price movements can make it challenging to enter and exit positions as planned. We recommend using API to do this, but it can be manual as well.

3. Liquidation Risk: When trading futures contracts with leverage there's a substantial risk of liquidation. This occurs if the market price moves against your position beyond your liquidation price, resulting in the automatic closure of your position by the exchange. Such an event leaves you with an unhedged spot position and potentially significant losses. If you have 1 BTC and short 1 Futures Contract (1:1) you are better off, some people leverage up the basis trade to juice returns.

Weka’s Thoughts: Patience and Perspective

And now for some exposition before the final trade example. Besides Marty’s expertise in derivatives trading, I wanted to bring you a different perspective on finding trade opportunities in the space.

The crypto landscape is a busy one – memecoin metas created overnight, major launches every other week… one day you’re a millionaire and the next you’re back to night shift at McDonald’s. These unique markets make for great success stories, but those that fail to navigate them or learn as they go are doomed to fail.

By navigation I mean finding strengths or strategies that allow you to be profitable more than 50% of the time employing them… plays that allow you to stay at the table even when you get shafted by a -50% downturn. Arbitrage, airdrop farming, basis trades, you name it. Doesn’t matter. If you consistently make money doing it, it’s a win.

The basis trade is a good example – anyone can do it when funding is favorable but the people are lazy… they would rather get their daily hit losing money in the shitcoin casino. I would know, I am people. Have some patience friend, you don’t necessarily have to hit an overnight 100x to make it.

The moral of the story is that there are multiple ways to win at this game. You shouldn’t be browsing photoshopped PnL cards on Twitter nor should you be gambling on fresh launches. You should be finding and studying opportunities that are consistently profitable, and allow you to survive even if they go sideways. When there’s money on the floor, pick it up. When there is no money in sight, you don’t have to look for it inside a casino. 

In a market loaded with inefficiencies and PvP-esque environments, there is always a play to be made. Sometimes that play is only possible with a specific derivative; hence it’s so important to study each one. Whichever opportunity you are looking to exploit should dictate your instrument of choice.

Now, let’s get back to it. The last case study will be a classic example of positioning for traders that are less concerned with overnight success stories, and more concerned with winning.

Case Study: The Marty Classic (Selling Front-End Garbage to Fund the Long-Term Vega)

As with most trades, we are generally putting this on as a portion of the total portfolio. Usually we are managing a total options book and this strategy can be fairly simple, or as complex as you wish.

This strategy is a classic that long-term readers of the Marty newsletter should be familiar with. It focuses on selling short-dated options to collect premiums, which are then used to purchase long-dated options, usually calls. Let’s talk about it.

Long positions have positive Vega. Vega is an important metric that measures an option's sensitivity to changes in the volatility of the underlying asset. For those unfamiliar with Vega, I recommend visiting the Premia Academy for a detailed refresher.

The ideal time to implement this strategy is when market volatility is falling or muted but expected to rise in the future. Vols generally get crushed post-event — look at the BTC ETF approval as an example. While others are getting chopped to bits during times like that, we are taking the cheap vols and positioning for the next event.

The core of this strategy involves selling front-dated contracts to gather premiums, which are then used to buy long-dated calls, aiming to make the trade at no net cost. However, it's important to recognize that this strategy is not easy, and requires careful portfolio management.

There is a variation of this trade that involves holding spot, selling 1:1 perpetual contracts (perps), and collecting funding when it's in your favor. You then use these funding payments to buy long calls at no cost to you as they are paid for by the funding. Your total position is long BTC, short BTCPERP while collecting funding. The long BTC and short BTCPERP make your USD value stay the same, while collecting the funding and taking it to buy calls. If BTC goes up, you cash and profit from the long calls. If BTC is down or flat your USD value is the same due to long spot short perps, you miss out of the upside of the long calls as they didn't cash.

It’s crucial to remember that selling options is not without risk. Proper management of your options book is essential. Often, traders overlook such strategies, instead opting to chase newer but potentially less effective strats.

Conclusion

Congrats, you made it this far! I won’t keep you too long, let’s just gather some of our thoughts…

Exploring different derivatives isn't just an educational experience — it's a pre-requisite for your trading success. Each financial instrument has its strengths. Options offer control and measured risk, allowing you to navigate market volatility with more certainty. Perpetual swaps allow for continuous trading but come with their costs, notably in the form of funding fees.

There's no one-size-fits-all answer here. Your choice between options and perps should align with your trading strategy and market outlook.

Knowledge and well-planned application is your most valuable asset in this game. Armed with the right information and strategies, you’ll be better positioned to make wise decisions that can lead to consistent success. Trade wisely and keep seizing those opportunities as they arise. The market is always moving, and so should you.

If you have any questions or feedback, feel free to reach out to Weka or Marty via DMs. Remember, knowledge is profit my bros. Use it wisely.

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