An option is a type or derivative contract that grants the purchaser the right, but not the obligation, to purchase or sell an underlying asset at a fixed price before (or after) an expiration date. The “call” option allows you to purchase the underlying asset, while the “put” option allows you to sell it.
Options, like other derivatives, are contracts that allow traders speculate on future prices of underlying assets. They can be settled in cash (U.S. Dollars) or actual cryptocurrency (bitcoins, ether, and so forth).
Deribit, the world’s biggest crypto options platform, settles crypto options contracts with cash. OKEx, the second-largest cryptocurrency options exchange, physically delivers crypto assets for investors when they exit a trade. When a trader exits a bitcoin option trade via OKEx, they get their profits in bitcoin.
How Crypto Options Work
There are two types of crypto options available:
- American: A buyer can cancel the contract at any point before the expiry date.
- European: A contract that a buyer cannot exercise at the time of expiry
It is worth noting, however, that European-style options cannot be exercised before expiry but can be traded (sold or closed early) if the buyer so chooses.
Types Of Crypto Option Trading
There Are Two Types Of Options Available:
- Call: You have the right to purchase the underlying asset
- Simply put: The right to dispose of the underlying asset
This is how options trading works: A seller of options “writes” or creates call and put option contracts. Each contract has an expiration day – the date by which it must be settled – and a strike price – the price at which the buyer of options can buy or sell the underlying asset after expiry (or earlier if it is an American-style option).
The options seller lists the contracts on a cryptocurrency options exchange. An option seller can sell into the exchange, and sometimes the buyer can place an order.
A “premium” is the cost of an option. This sounds like insurance. A person purchasing a put, for example, is buying protection against the downside. If the price of the underlying assets falls below the strike price the option owner has a pretty good guarantee that the writer will purchase the asset at the fixed price.
The premium price is based on the remaining time, implied volatility (the expected standard deviation in the price of the underlying assets price during the contract’s beginning and ending dates), interest rates, and the current value of the asset.
- In the money (ITM), a call is when the strike price of the underlying asset is lower than its current price. It’s when the strike price is lower than the current price for a put.
- At the money (ATM): This is for both a call or a put. It’s when the strike equals the current price.
- Out of the Money (OTM), For a call, it is when the strike price exceeds the current price of the asset. For a put, it’s a call when the strike price is lower than the current price.
A trader who wants to purchase a call option (the right of buying an asset) at a strike price lower than the current market price will need to pay significantly more for the contract. The contract is already “in the cash” and has intrinsic value. However, this does not mean that the price of the contract will remain above the strike price until it expires.
How much an option’s premium cost will be affected by the current value of the underlying asset.
What Are The Option ‘Greeks?
Although it may sound strange, option greeks refer to four additional factors which can affect the price of an option premium. These symbols were first used in options trading in 1973 when American economists, Robert Merton, Myron Scholes, and Fischer Black introduced a mathematical formula known as the “Black-Scholes Model” to standardize pricing options.
Before the Black-Scholes Model was created, there wasn’t a clear way to determine the fair value of an option contract. This system is used to price European-style options. Other pricing methods, such as the Binomial method, can be used to price American options before they expire.
The Black Scholes model looks like this:
C0 = S0N (d1) – E-rTN (d2)
Where d1 = [ln(0)/X] + (r+ s2/2)T]/s T
And d2 = D1 – T
Each factor can be attributed to a greek symbol: theta (Th), Delta (D), Gamma (G), and Vega (not an actual Greek Letter).
Theta: Theta is the time remaining before the option expires. The options price will rise if there is more time left. It means that the option can expire in the money more quickly.
Delta: This is the ratio of the option price to the price of the underlying asset. It is the probability that an option will be in-the-money upon expiration. Delta is 0.5 when an option is “at the money”. This means that a call option that was “at-the-money” will increase $0.50 if the price of the underlying asset goes up by $1. Delta for a call option will rise with a higher price and vice versa for a put. Volatility also increases delta because the chances of options being in-the money at expiration are higher. For calls, the delta score is 0 to 1, and for puts, it’s -1.0 to -0 for puts.
Gamma: Delta doesn’t have a fixed value. It fluctuates depending on whether the option is in-the money or out-of-the monetary. Delta also drops when the time approaches expiration (that’s, theta is closer to 0). Gamma is the name for this change in delta.
Vega: This is what the market considers the volatility (or standard deviation) of the underlying asset over the period to expiration. The more volatile the underlying asset is, the more likely it will become profitable. Therefore, it becomes more expensive. It is interesting to notice that implied volatility is often a “plug” number. It is calculated by combining all the “greeks” and the premium of an option in the market to arrive at what the market believes the underlying asset’s volatility will be. This is the most important “greek” of all. Options traders often declare an option’s premium using its “implied vols”, rather than its dollar or bitcoin amount. This is a convenient way for them to standardize different options on one underlying asset.
Selling Of ‘Naked’ Calls
What does it mean for you to be “naked” when you have options? It’s simply taking on an option position without taking on the other (“covered”) position in the underlying asset.
If a person sells a call, she is actually shorting the underlying assets unless she also purchases the asset. A naked seller of a put is also effectively long on an underlying asset, unless the put seller also sells it.
Naked calls (to purchase) and put (to sell), are more risky types of options positions that can lead to huge losses.
An option seller may own the underlying asset in order to protect against any price movements that could cause losses.
How Crypto Options Trading Differs From Traditional Options Trading
There are two main differences between trading traditional options and crypto options. The crypto market is open 24/7, while traditional financial markets are closed Monday through Friday from 9:30 a.m. until 4 p.m. ET. The price of crypto markets is more volatile than traditional ones, so it tends to fluctuate more often and more sharply.
This high volatility has the advantage that traders can potentially earn higher returns if the market turns in their favor. There will be a larger difference between the strike price (or settlement price) at expiry.
Crypto Options Trading Platforms
How Popular Are Crypto Option Trading
On February 21, 2021, the bitcoin options open interest, which is the total amount of money in unexpired options contracts held by bitcoin options holders, reached an all-time record of $13 billion.
Lennix Lei, OKEx’s director of Financial Markets, says that the options market is dominated by institutional traders. He expects that retail options trading will increase over 2021, once tailored products are available.
“We have seen a 10x market increase in volume and open interest since we launched Options trading in January 2020.” This upsurge is mainly being taken up by professional traders and institutions, with very little engagement from speculative retail traders.
He said, “This pattern is similar to the traditional space where retail traders usually access the market via Structured Products.” When OKEx Structured Products launches later this year, we expect to see a rise in retail options trading.
Shaun Fernando, Head of Risk at Deribit also stated that options trading is becoming more popular among retail traders.
Since its inception in 2016, Deribit’s options have grown by over 1,000x since then. He said that it was initially driven by institutions but now retail has also joined the party.