These exotic financial instruments are coming to a cryptocurrency near you! These stalwart trading strategies are finding a new home in the cryptocurrency world.
Options come from a class of investments called derivatives, so named because they are “derived” from regular assets, like gold, financial pairs or in this case bitcoin, with bitcoin options. With a bitcoin option (or any other option) you enter into a contract to buy or sell that asset at a defined price. This is called the strike price, and you’re essentially gambling on which way the market is going to move in relation to it and then taking advantage of the price differential between the changing market rate and the strike price in your bitcoin options contract.
This might make it sound very modern, and with bitcoin options it is, but derivatives have been around since the time of the Greeks, who used contracts like this to bet on the price of olive crops! These days the worldwide market for derivatives is worth an estimated $500 trillion, so what’s the secret of their enduring appeal and what does this phenomenon mean for bitcoin options?
For individual traders, options allow them to make money from speculation and to also hedge their positions, a valuable means of protection in markets that can move like the high seas. Every options contract has a “writer,” or seller, of the option and a buyer. The buyer pays a premium which is calculated using a few different criteria. One of these is called “moneyness,” which measures an asset’s present price in relation to its strike price, duration, and volatility. The writer makes money from receiving the premium.
In the case of bitcoin options, these may benefit long-term holders and give miners the chance to hedge their positions and make money by selling them. A speculator will be able to reduce downside risks and receive upside exposure at a fraction of the cost that comes with speculation through ownership.
Options may seem like rolling dice on a bigger scale, but analysis by the Journal of Finance has shown that they can actually help the health of the market as a whole. This means that Bitcoin options also have the potential to do that too.
There are two types of options contracts, known as “call” and “put” options. With the first one, the buyer may decide to buy the asset featured in the contract at a set price, and with the second one, they may choose to sell an asset for a set price.
Traders may use them to speculate and to hedge their portfolios. Someone who buys a call makes money when the price of the underlying asset is higher than the strike price. They have bought the option to buy the asset at a certain price, so if the market moves and the asset now costs more on the open market, the buyer may buy cheap and sell it at a profit, and the buyer of a put has bought the right to sell at a certain price. Let’s take a look at how they work in different scenarios.
If someone buys a call option, they do so because they think that the price of the underlying asset will go up. Of course, a trader who believes that’s going to happen could just buy the asset itself, but then they would be directly exposed to the price risk of the asset up to the principal in its entirety––which is particularly risky with an unpredictable asset class. But when they buy a call, the risk is limited to the level of the premium paid to buy the option, and the amount of profit is how much the spot price is over the strike price plus the premium. For instance, if the strike price is $200 and the premium is $20, then a spot price of $240 would yield a $20 profit.
Something else that traders may do if they think the price of an asset will go up is to write (meaning sell) a put option. When they do this, traders agree to buy the underlying asset for the strike price if the buyers decide to sell. If the asset’s spot price rises above the strike price, buyers won’t sell, and the person writing the option makes money off the premium.
If traders think the price of a particular asset will fall, they goodbye a put option, which gives them the chance to sell at the strike price, rather than shorting the stock. In a similar way to the Long Call already described, this reduces the chance of losing to no more than the cost of the premium. When you buy a put option, you make money if the spot price is less than the strike price by more than the cost of the premium. So, for instance, if the strike price is $200, and the premium paid was $20, then a spot price of $180 will break even, and anything lower will be profit.
If traders think a price will go down, then they may write (sell) a call option. In this situation, they agree to sell the underlying asset at the strike price if buyers use their right to buy. Similarly to the Short Put described already, this approach is designed to pick up the premium on the option, while buyers choose not to use their option; this happens when the spot price is below the strike price. If the spot price goes higher than the strike price, the person who wrote the call must sell the asset for less than it’s worth. This approach is often used for a covered call strategy, as described below.
Although options are often used for entirely speculative reasons, they are best used as a tool to mitigate risk. By combining the four basic options trades we’ve mentioned already with the two basic stock trades (long and short), investors may create a range of more sophisticated strategies to optimize their portfolios with bitcoin options.
Bitcoin options can be very useful as part of an overarching trading strategy. You can use a few of them in combination to reduce your risk exposure as well as to make money.
Covered Calls are popular. Traders use it when they think an asset will rise over time but not straightaway. So, they sell a call option on it and get paid the premium. Bitcoin miners sometimes use futures to hedge their mining activities. They might sell a $300 call option with a strike price of $10,000, and so make money even if a price increase occurs.
A Protective Put can be used to hedge a long-term investment. Unlike a covered call, which limits the upside of an investment if the call option is used and the asset disposed of, a protective put is intended to put a limit on the downside without negatively affecting the upside. In such a case, traders purchase a put option on long-term investment to hedge against possible losses, with a limit on upside equal only to the put’s premium. If investors have been increasing exposure during this recent bear run with predictions of a rally, they may want to buy a protective put for $200 at a $6,500 strike price, putting a limit on their downside.
Covered calls and protective puts are only the start of the potential for bitcoin options strategies. Other strategies include collar strategies, straddle strategies, strangle strategies, butterfly strategies and more. They can be arranged in terms of market sentiment — bullish, bearish or neutral — and probable volatility.
With the Bitcoin options market in the early stages, there will probably be arbitrage trading opportunities, in line with the Put-Call Parity principle, which says that the difference between a call and a put option of the same expiry and strike price is equal to the difference in the current spot price and strike price, discounted to present values.
C - P = S - K * D
C = call option value, P = put option value, S = spot price, K = strike price and D = discount factor.
When this equation isn’t true, it means there is an arbitrage opportunity for traders to exploit, particularly in the initial days of these options markets.
Why are Bitcoin options so pricey?
The cost of options (known as the premium) is arrived at by the market and is based on intrinsic and extrinsic value. Intrinsic value is the difference between the underlying asset spot price and the strike price but only in reference to a positive value to the option holder. When an option won’t benefit the buyer, it is described as having zero intrinsic value and only extrinsic value, like time value, strike price and volatility. There are a number of factors and very complicated valuation models that can be used to work out the value of different options, but some of the basics are quite simple. When an option is “in-the-money,” this means its holders will the advised to exercise their option, and so the option is said to have intrinsic value. An in-the-money option is easier to value, as the intrinsic value is set, and the extrinsic value is a function of the risk associated with time, value, and how volatile it is.
An out-of-the-money option, on the other hand, has no intrinsic value, so its price is entirely dependent upon those extrinsic value factors. The premium is like a fee that the writer of the option takes in exchange for the risk that comes with selling. That’s why it shouldn’t be surprising that an asset as volatile as Bitcoin has such expensive premiums.
Within the past year, additional options trading platforms and exchanges have emerged along with some clearer information on regulations. This is crucial as larger investors and institutions need to know that these instruments are well managed. The CFTC has begun to give regulatory approval to providers like LedgerX and Bakkt, with CME Group coming soon.
Bitcoin options trading platforms include Deribit, LedgerX, IQ Option, Quedex, Bakkt and OKEx. All of these should be properly researched before using them. OKEx is the first platform to let traders buy and sell options, which is obviously immensely beneficial for those who want to take advantage of all of the basic strategies that we’ve mentioned here. More advanced trading options may follow in time for enhanced trading and hedging. Their anti-manipulation system is robust and includes crypto settlement with a marked price at settlement time and round-the-clock API-supported trading.
The financial infrastructure of cryptocurrencies continues to evolve, and as it does so, traders may gain the levels of confidence they need to fully utilize these new assets.