Thales of Miletus “put a down payment on the seasonal use of every olive press in the vicinity of Miletus and Cios, which he got at a low rent. The harvest turned out to be extremely bountiful, and there was demand for olive presses, so he released the owners of olive presses on his own terms, building a substantial fortune in the process.”
-Nassim Nicholas Taleb. Antifragile: Things that gain from disorder.
If you’ve spent any time trading Bitcoin or being interested in the asset, you’ve no doubt heard of crypto options.
Options are part of an expanding list of financial products available to crypto traders and businesses. Crypto options provide users looking for a broader set of options (pun intended) to express their opinion on crypto, hedge a position, and earn premiums.
Options on BTC are the most common. For example, options on BTC futures as provided by Bakkt.
So what are options, and how can a crypto trader use them?
Options are not lottery tickets
The first thing to remember about options is that they have been around for a long time. Much of what is used in crypto on the options side, comes from the legacy financial system.
These options are not to be confused with “binary options,” which are basically daily lottery tickets based on some underlying asset price. Next time you’re at a dive bar and see the miniature slot machine over in the corner, think binary options.
The options we’re talking about are financial contracts between a buyer and a seller that have a defined set of specifications.
Options are a right but not an obligation
As the buyer of a contract, you pay a fee, which is called a premium. The premium goes to the seller of the option contract, which is typically a market maker or professional trader, and sometimes an institution.
The premium you pay as the buyer gives you the right to buy or sell a specific amount of an underlying asset, at a given strike price, on a specific date in the future. These terms are part of a detailed set of contract specifications similar to a futures contract.
When you buy an options contract, you have three actions you can take between purchase and expiry.
> You can sell your option for a capital gain (or loss)
> You can exercise the option, put up the funds to buy (or sell) the asset specified in the contract at the strike price. Or you can allow it to expire and take the loss on the premium
> Your total risk on the trade, if you buy an option, is the premium you pay for the contract.
Naked bulls and covered bears
Buying a call option is considered a bullish position giving you the right to buy the underlying assuming it will go higher. A put option is considered a bearish posture where you have the right to sell the underlying based on a belief of lower prices at some point in the future.
Selling options contracts is called selling premium. In exchange for assuming the risk of the position, the seller earns the premium as a fee.
You will eventually hear the terms covered or naked options, these apply to selling options contracts.
A covered call seller owns the underlying asset, while a naked call seller does not.
A covered put seller is also short the asset. The naked put seller has no position.
Now, straight up call and put buying are pretty basic. There are a variety of other more sophisticated options trading strategies like straddles, strangles, condors, and so on.
These are best suited for professionals and market makers.
Show me the…in, out or at the money?
Another group of terms you will eventually hear about are: In, out and at the money.
When a call option is described as in-the-money, that means that the price of the underlying asset is higher than your strike. If you bought a put option, in-the-money is when the price is lower than your strike price.
At the money means your option is at the strike price depending on the contract type.
Out of the money means the underlying is below the strike price, and it will likely expire worthless as a loss. And of course technically, unless the price exceeds your strike plus the premium you paid, you don’t actually have a profit.
Option premiums are based in part on whether they are at, in or out of the money. Premiums on in-the-money options are the typically the highest, followed by at-the-money, and the lowest priced premiums are out-of-the-money.
Time and volatility affect your price
Now the level of premium on each contract also reflect some other elements, including volatility and time to expiry.
A longer time to expiry means more risk and, therefore, will mean more premium to compensate the seller for taking that risk. And volatility means more risk for which the seller will want to be compensated as well.
Premiums reflect different in, at and out of the money scenarios and time value based on the strike dates and prices.
BTC call for a halving
So how could you use a plain vanilla option to trade?
For individuals, you would probably use a simple buy of a call or put option.
Let’s say you think BTC is going higher due to the halving, which looks like it will occur in May. But you think it could start moving in the next couple of months in anticipation.
And let’s say that BTC is trading around $8800 USD.
One approach would be to simply go to a crypto exchange like Bitvo and buy your BTC with cash or QCAD and hold onto it in your wallet. You could also trade the halving using a catalyst type trade. These are pretty straightforward transactions since there is no margin trading on a Canadian crypto exchange as of today.
Another approach would be to buy a call option.
So hypothetically, you could buy a March 27, 2020, BTC call with a strike price of $10,000. The premium might be around $800 per contract. So your break-even would be the strike, plus your premium or $10,000 + $800 or $10,800.
This means that unless BTC closes above $10,800 at expiry on March 27, 2020, you will have a maximum loss of $800 or the premium you paid.
If you decide to exercise the contract at expiry, you would put up your $10,000 for the right to buy the BTC at the strike price. Then you would sell the BTC. Your profit would be the difference between your sale price minus your strike price and premium paid.
Just like futures, option contract details matter
Now there are a few things you need to know before you consider using options.
You should look carefully at the contract and understand the specifics of each option that you trade. And you need to be aware that BTC options on different markets may have different contract terms just like with futures. That includes options on BTC futures.
For example, do your options settle in cash or BTC?
You also want to know what one contract means in terms of amounts of BTC. Is one contract equal to one BTC, or is the amount different?
You want to understand the expiry specifications. In options, there is American and European expiry. American means you can exercise the option at any time throughout the life of the contract giving you maximum flexibility. European option expiry means you can only exercise the option at the expiry date.
You should also understand what markets the contract uses for the spot price at expiry, particularly in the case of European expiry.
There are often specific trading times where you can transact in options. Unlike the crypto market, these are not 24/7 markets typically.
How pros can use BTC options
What are some ways that professionals might use options contracts?
Market makers selling premium will often cover the position risk by buying or selling the underlying or making an offsetting options trade. The objective is to earn the premiums and spreads with a minimum of risk.
Fund managers sometimes sell options as a way to earn a revenue stream on existing holdings. If you were long BTC and think that the upside may be limited in the short term, you might sell out of the money covered calls to earn extra premiums. Here they can use the premiums to reduce the cost basis of their position.
A fund manager might also buy calls as a way to participate in possible upside without committing too much capital. Or they could use it as a risk management option by defining the maximum sustainable loss, which would be the premium paid.
The BTC replacement option strategy
One could also use options as an “asset replacement.” You would do this if you own BTC but are concerned that there is a significant risk of downside, but want to be able to participate in possible upside. Here you would sell your BTC and replace the position with the equivalent amount call options. The option limits your downside to the premium you paid while allowing you to participate in any upside before expiry.
Buying puts can be used as a hedge against a price decline in BTC holdings. Here, the option acts as a form of insurance, guaranteeing an exit price for the price of the premium.
In another scenario, a fund manager could sell naked puts as a way to earn premiums while they wait for the price of BTC to come down. They would sell puts at strike prices that fit their trading thesis or strategy. If BTC trades lower and the contract is exercised, they are made long BTC, but with a better cost basis due to the premiums they received for selling the puts.
It’s important to remember that options contracts can be traded from purchase to expiry. Premium prices are not static and will move around with Bitcoin’s price as well as the increase or decrease in volatility and the amount of time left to expiry.
So options don’t have to be held to expiry. You can sell them.
Options aren’t for everyone, but they add an interesting dynamic for a variety of Bitcoin traders, speculators and hedgers. But the secret is to understand the product fully before you dive in.
The ability to define your downside while maintaining upside is a key benefit for options buyers. But it can also mean paying a lot of premium for the right, but not the obligation to use that protection.
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