Buying crypto options can often offer investors a relatively low-cost and low-risk solution for trading digital assets compared to trading crypto futures or perpetual swaps.
An “option” is a type of derivative contract that gives its purchaser the right – but not the obligation – to buy or sell an underlying asset at a set price at (or, in some cases, before) an expiration date. The right to buy the underlying asset is known as a “call” option while the right to sell is known as a “put” option.
See more: How to option trade crypto
Like other derivatives, options are simply contracts that allow traders to speculate on the future price of an underlying asset and can be settled in cash (U.S. dollars) or actual cryptocurrencies (bitcoin, ether, etc).
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The world’s largest crypto options platform, Deribit, settles crypto options contracts in cash, while the second-largest crypto options exchange, OKEx, physically delivers crypto assets to investors upon exiting a trade. For example, when a trader successfully exits a bitcoin option trade on OKEx, they receive their profits in bitcoin at settlement.
How crypto options work
There are two styles of crypto options:
American: Where a buyer can exercise the contract at any time before the expiry date
European: Where a buyer can only exercise the contract at the moment of expiry
It’s worth noting that although European-style options can only be exercised at expiry, they can still be traded (sold to someone else) or closed out early if the buyer chooses.
There are two different types of options:
Call: The right to buy the underlying asset
Put: The right to sell the underlying asset
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The options trading process goes as follows: An options seller “writes” (creates) call and put options contracts. Each contract has an expiration date – when the contract must be settled by – and a “strike price.” This refers to the price at which the contract buyer has the right to buy or sell the underlying asset upon expiry (or before if it’s an American-style option.)
The options seller then lists the contracts on a crypto options exchange. Sometimes, the buyer of an option can also place an order on the exchange and an options seller can sell into it.
The cost of an option is usually referred to as a “premium.” If that sounds like something from insurance, in many ways it is. For example, a person buying a put is doing so as downside protection. In case the price of the underlying asset falls below the strike price, the option’s owner is pretty much guaranteed the options writer will buy from the owner the asset at that fixed price.
The price of premiums is relative to the time remaining on the contract, implied volatility (the expected standard deviation of the underlying asset’s price during the contract’s start and end date), interest rates and the current price of the underlying asset.
The current price of the underlying asset plays an important role in how much an option’s premium costs.
In the money (ITM): For a call, that’s when the strike price is lower than the current price of the underlying asset. For a put, it’s when the strike is higher than the current price.
At the money (ATM: For both a call and a put, it’s when the strike is equal to the current price.
Out of the money (OTM): For a call, it’s when the strike price is higher than the current price of the underlying asset. For a put, it’s when the strike is lower than the current price.
A trader wanting to buy a call option (the right to buy an asset) with a strike price that is lower than the current market value of the underlying asset will have to pay a significantly higher price for the contract. This is because the contract is “in the money” and already has intrinsic value. Of course, that doesn’t mean the price will continue to stay above the strike price before the contract expires.
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Example: The price of one bitcoin at the start of January is $34,000 but Bob thinks by the end of February the price will be much higher. He decides to buy 10 European-style call options at a strike price of $36,000 for a 0.002 bitcoin premium per contract, which expires on Feb. 28.
0.002 bitcoin at $34,000 = $68 at the time Bob purchases the call options. 10 x 68 = $680.
Each contract gives Bob the right to purchase 0.1 of a bitcoin at the price of $36,000 per coin. This means Bob can buy one bitcoin at $36,000 when the contract expires at the end of February. (10 x 0.1=1)
In scenario A: Upon expiry, bitcoin’s price is $40,000. Bob exercises his call option and makes a $4,000 profit (40,000-36,000=4,000). Minus his premium, Bob walks away with $3,320.
In scenario B: Upon expiry, bitcoin’s price is $32,500. Bob decides not to exercise his call option because it’s “out of the money.” All in all, Bob makes a loss of $680, the price he paid for the call premium.
Understanding option ‘greeks’
Option greeks might sound exotic but it simply refers to four additional factors that can influence the price of an option premium. The use of these symbols in options trading was first introduced in a mathematical formula called the “Black-Scholes Model,” a method created in 1973 by American economists Fischer Black, Myron Scholes and Robert Merton to standardize the process of pricing options.
Prior to the Black-Scholes Model, there was no clear method to assess the fair value of each option contract. Now, this system is widely used today to price European-style options. Because American options can be exercised before expiry, other pricing methods such as the Binomial model are used instead.
In case you’re wondering, the Black-Scholes model looks like this:
C0 = S0N(d1) – Xe-rTN(d2) Where d1 = [ln(S0/X) + (r + σ2/2)T]/ σ √T And d2 = d1 – σ √T
Each factor is attributed to a greek symbol; theta (Θ), delta (Δ), gamma (Γ) and vega (not an actual Greek letter).
Theta: That’s the amount of time left until the option expires. The more time that’s left, the higher the options price. After all, it means there’s more time for the option to expire in the money.
Delta: Measures the change in the options price given the change in the underlying asset’s price. Think of it as the chance the option has of being in-the-money at expiration. When an option is “at-the-money,” delta is 0.5. That also means when the underlying asset’s price moves up by $1, a call option that was at the money will go up $0.50. The higher the price, the higher the delta for a call option and vice versa for a put. Delta also rises with volatility because there’s an increased chance of the options being in-the-money at expiration. The delta scores from 0 to 1.0 for calls and -1.0 to -0 for puts.
Gamma: Delta isn’t a static number. It changes depending on how in-the-money or how out-of-the-money the option gets. As well, when time gets closer to expiration (that is, when theta gets closer to 0), delta also falls. That change in delta is called gamma.
Vega: This tracks what the market is forecasting as the volatility (in other words, the standard deviation) in the underlying asset in the time until expiration. The higher the volatility in the underlying asset, the more likely the option is expected to become profitable and therefore becomes more expensive. What’s interesting to note is that implied volatility is usually a “plug” number. That is, it is calculated using all the other “greeks” above and the premium of the option in the market to come up with what the market expects the underlying asset’s volatility to be. Of all the “greeks,” this is the one that will come up most. For options traders, they often state an option’s premium by its “implied vols” rather than even its dollar or bitcoin amount since it offers a convenient way to standardize different options on the same underlying asset.
Understanding selling ‘naked’ call and put crypto options
What does it mean to go “naked” with options? Simply, it’s taking on an options position without taking on the opposite (“covered”) position in the underlying asset.
For example, someone selling a call is effectively shorting the underlying asset unless she also buys the asset. Likewise, someone selling a put naked is effectively long on the underlying asset unless that put seller also sells the asset.
Selling naked calls (to buy) and puts (to sell) are much riskier types of option positions and can result in huge losses.
Normally, options seller will own the underlying asset to cover any losses if the price moves against them. In scenario A above, let’s say the trader who created the options contract that Bob bought decided to purchase one bitcoin at the time the contract was created ($34,000.) After the contract had expired and bitcoin’s price had risen to $40,000, the options seller would’ve ended up losing $34,000 (because the price of the bitcoin owned would’ve increased to $40,000, covering the loss).
Now let’s imagine the options seller decided not to buy one bitcoin at the time he created the call contract. Upon expiry, he would’ve had to go to a cryptocurrency exchange and purchase one bitcoin at $40,000 to settle the contract, meaning he would’ve lost an additional $4,000.
So why would anyone sell naked call and put options? Well, the main appeal of selling naked options is the options seller doesn’t have to invest any of his or her own capital upfront. Also, there are only three possible outcomes to any options trade.
The price of the underlying asset moves in the buyer’s favor (Bob) and the options seller loses money.
The price of the underlying asset stays the same so the buyer chooses not to exercise the contract.
The price of the underlying asset moves against the buyer so that person chooses not to exercise the contract.
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Out of the three scenarios, the options seller stands to gain from two of them. The seller has to calculate the risks (based on the volatility of the underlying asset) of earning premiums without having to invest any capital upfront to cover the call and put options created.
How is crypto options trading different from traditional options trading?
The main differences between trading traditional options versus crypto options are that the crypto market runs 24/7, whereas traditional financial markets are only open Monday to Friday 9:30 a.m. to 4 p.m. ET. Crypto markets are also typically more volatile, meaning the price tends to rise and fall more frequently and sharply.
The benefit of this high volatility is that traders stand to potentially make better returns if the market goes the way they predict because there will be a greater difference between the strike price and the settlement price at expiry.
What platforms provide crypto options trading?
How popular are they?
On Feb. 21, 2021, bitcoin options open interest – the amount of money held in unexpired options contracts – reached an all-time high of $13 billion.
According to Lennix Lai, director of Financial Markets at OKEx, the current options market is mostly dominated by institutional traders. However, he anticipates a rise in retail options trading over 2021 once more tailored products emerge.
“Since launching Options trading back in January 2020, we have seen a 10x market growth in terms of volume and open interest. Due to the hedging nature of options, this upsurge has mostly been taken up by institutions and professional traders, with limited engagement with speculative retail traders.”
He continued, “This follows a similar pattern to what is seen in the traditional space, where retail traders typically access the market through Structured Products. We expect to see an increase in retail options trading when OKEx Structured Products launch later in the year.”
Shaun Fernando, head of Risk at Deribit, also commented that options trading is becoming increasingly popular with retail traders.
“Since inception in 2016, Deribit has seen well over a 1,000x growth in options. It was initially … driven by institutions, but retail has joined the party, too,” he said.
Advantages over other derivatives
The main advantage of buying crypto call options (the right to buy), as opposed to other types of derivatives such as futures, is that a call buyer has no obligation to exercise the contract if he or she doesn’t want to. The risk for buying call options is limited to the price paid for the premium, meaning if the market moves against call buyers they don’t have to worry about incurring losses greater than their initial investment.
As discussed above, only option sellers are exposed to unlimited risk.
Crypto Options Trading, Explained
Crypto Options Trading, Explained