Bitcoin Options 101: What Are They and How Do They Work? — AAX Academy

In addition to Bitcoin futures, options contracts for Bitcoin constitute another popular product that both retail and institutional investors are looking to trade. In fact, options trading volume has increased from Q1 2020’s $8 billion to $45 billion in the fourth quarter of the year, realizing a total of $77.2 billion in 2020, according to TokenInsight.

As a result, digital asset options play an important role in the crypto space while providing multiple use-cases for traders and investors.

What Are Crypto Options?

Options contracts are a type of derivative representing an agreement between two parties to facilitate a potential transaction on the underlying asset at a predetermined price (called the strike price) before the expiration date.

While derivatives can cover various instruments — for example, stocks, bonds, commodities, currencies, and market indices –, in the case of cryptocurrency options, the underlying asset is Bitcoin (BTC), Ethereum (ETH), or another digital asset.

Digital asset options and futures contracts are very similar as they both represent agreements between two parties with a cryptocurrency as the underlying asset.

However, while the buyer and the seller are obliged to fulfill their commitments in the case of futures, contract holders don’t necessarily have to exercise their rights to trade the asset on the expiry date.

Buyers (contract holders) purchase options from writers (sellers) for a premium. Even if the buyer chooses not to exercise his rights, he still has to cover the premium’s costs.

The premium price depends on multiple factors, including the asset’s value, the strike price, volatility, and the length of the contract.

Increased volatility levels push the premium up; short time frames are cheaper. The reason for the latter is that traders have a lower chance of prices moving in favorable directions in shorter time frames.

Based on the offerings of brokers and crypto exchanges, we differentiate two types of options: European and American.

While American options allow holders to exercise their rights anytime before the contract’s end, their European counterparts are more strict.

Like with other derivatives, crypto options traders can use leverage to trade and increase their exposure. This could mean amplified profits, but highly leveraged positions also significantly increase your chances of losing the trade.

In addition to increased profit potential, traders can use crypto options to stabilize price fluctuations, hedge against market risk, and short digital assets.

How Do Cryptocurrency Options Work?

You can trade cryptocurrency options in two forms: call and put options.

While call options offer buyers the chance to purchase a digital asset at a predetermined strike price, put options allow holders to sell crypto at a given strike price.

Below, we have listed four example cases for trading cryptocurrency options on the market to understand how they work.

Purchasing a Call Option

Buying a call option signals bullish sentiment as the holder expects the underlying digital asset’s value to increase in the near future.

By purchasing a call option contract, the buyer can protect himself against high volatility.

For that reason, instead of purchasing the digital asset on the spot market, the trader hedges his position with a call option instead. As a result, the only risk he is exposed to is the option’s premium he has to pay to hold the contract.

In case the underlying asset’s value moves up significantly from the strike price by the expiry date, the holder can exercise his rights to make a profit.

On the other hand, if the cryptocurrency’s value is lower than the strike price, the holder can refuse to execute the trade to minimize his losses (although he has to pay the cost of the premium).

Purchasing a Put Option

While buying a call option is a signal of bullish sentiment, the holder believes the underlying asset’s price will go down when purchasing a put option.

However, unlike shorting the cryptocurrency, the put option holder is protected against a sudden price increase in the digital asset’s value.

In such a case, the put option holder can refrain from executing his contract before the expiry date, realizing only the premium’s price as a loss.

On the other hand, buyers will make a profit when the spot price is below the strike price by a larger amount than the premium paid for the contract.

Selling a Put Option

Interestingly, traders predicting bullish price changes can also make a potential profit by selling a put option.

Since put option buyers will choose not to execute the trade when the cryptocurrency’s spot value is higher than the strike price, sellers will profit from the premium.

However, while the premium provides more potential for a profit for option sellers, unlike buyers, they are obliged to trade the underlying asset when holders decide to exercise their rights before the expiry date.

For that reason, option sellers are not protected against losses like buyers (although they can still earn money on the premiums).

Selling a Call Option

Similar to purchasing a put option, selling a call option also provides traders a chance to benefit from bearish price movements.

Like with selling a put option, writers here generate profits from the premium when buyers don’t exercise their rights to trade the asset.

However, call option sellers will only profit when the asset’s spot value is lower than the strike price.

In the opposite case, they are obliged to execute the trade and realize a loss.

What Are the Most Popular Crypto Options Trading Strategies?

One of the main benefits of crypto options is that they provide a high level of flexibility to traders, allowing them to utilize a wide range of strategies.

Below, we have listed some of the most popular strategies traders use for crypto options:

• Protective put: Traders use the protective put strategy when they are already holding the underlying asset. To hedge against potential bearish price movements, you purchase a put option at the same or a similar strike price than your digital assets’ current value. In case the cryptocurrency’s price goes down, you can exercise your right to sell the option at the strike price, which will cover most part of your losses. On the other hand, if your assets’ value increases, you refrain from executing the trade and realize only the premium as a loss.
• Covered call: With a covered call, traders sell a call option while simultaneously holding the digital asset. As a result, you can make an extra income on premiums during bearish price movements as buyers won’t execute their trades. In the opposite case, the assets you hold will cover the losses of selling the call option. That’s why this strategy is called a covered call.
• Straddle: Here, traders purchase both a call and a put option with the same strike prices and expiration dates. The move may seem counterproductive at first as you are betting on both the decrease and increase of the underlying asset’s price. However, when market volatility is high enough, the straddle strategy allows you to make a profit from extreme price movements in either direction if the gains from the rises or falls are more than the total amount spent on premiums.

How Do Option Trades Impact the Crypto Market?

Crypto option trades rarely have a direct impact on the spot prices of the underlying cryptocurrencies.

However, large amounts of funds concentrating in out-of-money (OTM) options — call options where the strike price is higher than the spot and put options where the strike price is lower than the spot value’s — that are close to expiry can suddenly increase the volatility of the market and impact the underlying asset’s price.

If the overall market sentiment is bullish, it means that calls are the dominating forms of options for a cryptocurrency.

During a bullish scenario, market makers (those who provide liquidity on exchanges) may hedge the OTM calls they sell to buyers before expiry to purchase the underlying asset.

When lots of OTM options are expiring in a short period, doing so could create increased volatility and further drive up the cryptocurrency’s price.

Crypto Options: Useful Digital Asset Derivative Products That Are Still in the Early Stages

Crypto options are getting increasingly popular, but they are still in the early stages of adoption, especially if we compare their volumes with digital asset futures.

While the prior printed $77.2 billion in trade volume in 2020, futures trade volume amounted to $12.31 trillion in the same period.

Crypto options make the digital asset market more diverse, offering multiple use-cases for investors, such as hedging against market risks and increasing potential profits by leveraged trading.

Originally published at https://academy.aaxpro.com on February 23, 2021.