Trading options: Introduction and strategies
1 Introduction
This is an attempt at explaining possible trading strategies involving options, in a basic manner. The target audience is people that have a basic understanding of what options are and want to expand on that knowledge, although I do hope there’s something in here for everyone.
First of all, all example and strategies are operating under the assumption that it concerns European-style options (such as the ones found on Deribit). This has nothing to do with geography by the way:
- American-style options can be exercised at any point in time, right up until the expiration date.
- European-style options can only be exercised at the time of expiration.
It is very important to realize that you can still close an options position at any time by simple selling/buying (when long/short) the corresponding option (much like a swap or futures contract for example).
Secondly, avoid shorting options unless you are absolutely sure about what you are doing. I highly recommend the Deribit position builder to test out any ideas or positions you would like to enter:
https://pb.deribit.com/#/BTC/anonymous/default
Finally, always do your own research and don’t take this as financial advice.
2 Types of options
We distinguish 2 types of options: call options and put options:
- A call option gives the buyer the right to buy the underlying asset for a certain price (strike price) on a certain date (expiration or maturity date)
- A put option gives the buyer the right to sell the underlying asset for a certain price (strike price) on a certain date (expiration or maturity date)
It is important to understand that a call and a put are 2 different products. I notice a lot of people new to options struggle with this. For example: If I’m long in a put option it means I expect price to go down. That is however not the same as being short in a call option. Even though in both cases I’d be bearish, shorting (or selling) options has a different reward structure than longing (buying) them.
As you can see from the picture above, buyers of options have limited risk (price paid for the option) and unlimited gains, while sellers of options have limited gains (price received for selling the option) and unlimited risk.
I highly recommend people new to options to make sure they understand this.
There’s a lot of good and detailed materials on options around if you search for it.
For example: check out this list made by BambouClub and also make sure to check out his medium and Twitter page.
3 Options trading strategies
From now on, we will assume that the underlying asset of options is always Bitcoin. Furthermore, all profit calculations are based on the final settlement (at maturity date).
Note: As mentioned there is nothing that prevents you from taking profit earlier: options may only be exercised at maturity date, but you can always close a position by selling your long option position, or rebuy to close a short option position.
All graphs that follow were made using the Deribit Position Builder and show the combined PNL for each strategy. In order to understand how the PNL line of a combined position at maturity date is constructed, try recreating the position for yourself and see how the individual postion PNL lines look like.
3.1 Trading Bitcoin and an option
(Note that in this section all profit calculations are done in USD as it involves spot bitcoin)
We can distinguish 4 different strategies in trading a combination of Bitcoin and Bitcoin options:
3.1.1 Covered call
In the case of a covered call, we go long Bitcoin and short a call option for the same size. In this case, the long position in Bitcoin covers any losses the short call option might incur in the case of price jumps.
3.1.2 Reverse covered call
In this case, we short Bitcoin and take a long position in a call option. This way, when shorting Bitcoin you can still limit your loss when price does jump up.
3.1.3 Protective put
In the case of a protective put, we buy a put option and buy bitcoin. You can do this when buying spot Bitcoin, but are worried about further drops in price.
3.1.4 Reverse protective put
In this strategy we combine a short put option with a short bitcoin position.
3.2 Strategies involving spreads
For spread strategies we combine multiple positions in options.
(Pay-out calculated in BTC)
3.2.1 Butterfly spread
Butterfly spreads are useful for when a trader does not expect any large moves in price. As you can see the loss in case of a large move is limited, while profit is largest when price remains close to the spot price at the time of opening the position.
We create a butterfly spread by buying 1 call option with a low strike price (6000) and 1 call option with a high strike price (7000), combined with the sell of 2 call options (6500) close to the current spot price (6359). The strike price of the short position should be halfway between the strike price of the 2 long positions. All options have the same maturity date.
Note that the same result can be achieved using put options: Short 2 puts with a strike price of 6500, and buy 1 put option with a strike price of 6000 and 1 put option with a strike price of 7000. (try it out using the position builder)
3.2.2 Calendar spread
A calendar spread is another strategy for when you do not expect large movements in price. The difference with a butterfly spread however is that in the case of a calendar spread, the options will have the same strike price but different maturity dates (as opposed to different strike prices but the same maturity date).
A calendar spread can be created by selling a call option and buying a call option with the same strike price, but a longer maturity date. PNL is calculated on maturity date of the short call option and assumes you close out your long call position early at the same time by selling it.
3 variations on this exist: neutral, bullish and bearish calendar spreads. Depending on your sentiment, the strike price for the option will either be close to (neutral), above (bullish) or below (bearish) the current Bitcoin price.
3.2.3 Diagonal spread
In the case of diagonal spreads, we combine options with both different strike prices and maturity dates. I am not going to get into this simply because of the number of possible variations, but I highly encourage you to try it out using the position builder. I want to keep emphasizing this, it’s the only way you’ll learn.
3.3 Combining calls and puts
This is why I love options trading: when you start combing long and short positions in both call and put options with different maturity dates and strike prices and you can create a whole range of strategies. I’ll discuss the most well-known below:
3.3.1 Straddle
We can create a Straddle by buying a call and put option with the same maturity date and strike price. This strategy makes a profit when there is a large movement in price.
In case you expect a large move in price and have a reason to believe this move is to the downside or to the upside, you can use a so-called strip or strap strategy.
In the case of a strip, you combine 1 long call option with 2 long put options. (bearish sentiment)
In the case of a strap, you combine 2 long call options with 1 long put option. (bullish sentiment)
Another variation on this is the Strangle. In this case, we buy a put and a call option with the same maturity date, but different strike prices, whereby the strike price of the call option is higher than the strike price of the put option.
The difference with a Straddle is that your initial cost for purchasing the options will be lower, but at the same time you require a greater price move to end up in profit.
4 Considerations
The above hopefully gives you an idea of the possibilities options can provide. They can be used for speculative purposes (i.e. spreads) or hedging purposes (i.e. protective put). When combined, you can use different strategies as building blocks to create new strategies.
What I did not discuss however, is the price of options itself. It is important to realize that the price of an option will have a large impact on the potential profitability of your trades or strategies. This means that not all strategies can be used at any given time.
A good example of this are Straddles and Strangles. These are strategies that you should typically use in periods of low volatility: The cost of purchasing will be lower and the chance of a large price move becomes greater.
For now, just remember that both volatility and time to maturity have a large impact on the price of options. This is actually quite logical: when selling an option during highly volatile periods, your risk as a seller becomes much larger and this risk must be compensated in the form of higher prices. The same goes for time to maturity: the greater the time to maturity, the more risk (uncertainty) you take on as a seller. I will go deeper into this in a possible future article.
Looking forward to feedback, comments and questions anyone may have.
Sign-ups on Deribit via my ref link are highly appreciated.
