Crypto Options — A Primer
Decentralized Finance or De-Fi has expanded the horizons of the cryptocurrency ecosystem by bringing powerful traditional investment tools to the space. Trading tools such as options and futures bring much needed hedging and speculative options to the cryptosphere.
Contrary to popular belief that they are purely speculative in nature, options and futures are just another type of trading instrument and if used correctly can offer many advantages to crypto investors. This post serves as a basic intro to options for the uninitiated.
What are Options?
Options are contracts that offer the bearer the right but not the obligation to purchase or sell some asset according to a predetermined price at the time of maturity of the contract or before.
Options are a type of derivative security and their price is linked with the price of an underlying asset. Holding an option contract gives the user freedom to purchase or sell the asset without the obligation to do so.
A call option gives the contract holder the right to buy the underlying, while a put option, the right to sell the underlying. With Options a trader can do four things — buy calls, sell calls, buy puts and sell puts.
Components of an options instrument.
The various components that go into the making of an options instrument are: the underlying security, the expiry date, the strike price, is it a put or a call.
For example, on Deribit, a Bitcoin options exchange, the instrument “BTC 21DEC21 44000 C” denotes a Bitcoin call option expiring on 21st december 2021 with a strike price of 44000.
Buying a stock gives the trader a long position, while purchasing a call Option gives them a potential long position for the underlying stock. On the other hand, purchasing a put Option gives the trader a potential short position on the underlying.
Buying a put or a call option involves the payment of the premium for the privilege of having the option to exercise a buy or a sell, regardless of whether the option is exercised or not. An option that is not exercised by it’s end date, expires worthless.
The maximum loss with buying a call or a put option is 100% i.e. the premium paid for the option. The maximum upside with a call option is theoretically unlimited as a stock can keep rising. The maximum upside with a put option (which is a bet that the stock will go down) is 100% as the maximum a stock can fall to is 0.
The notion of writing an option is for sophisticated traders who really know what they are doing. One writes put or call options with a bullish (in the case of a put) or bearish (writing calls) slant with the intention of collecting the premium that one is willing to pay for it.
Options writers are basically acting as market makers for those who wish to buy options. The best outcome for an options writer is that an option expires worthless, which means they have collected the full premium without having to fulfill any obligation or deliver the underlying.
One has to bear in mind that the potential downside for writing either call or put options is many multiples of the collected premium (100s of percent of the initial premium collected) and therefore should remain within the purview of sophisticated operators *or* be used in conjunction with other strategies as a hedge or income generator e.g. covered calls, spreads and so on.
Options Valuation — The Greeks
There are various components that go into determining an options price. Without a proper options valuation model to guide one’s decision making process, one party, either the seller or buyer could be paying a heavy premium or selling for a heavy discount.
According to the Black-Scholes Model to assess the fair value or premium of each Option contract, the variables are denominated with greek alphabets theta (Θ), delta (Δ), gamma (Γ), and vega.
Black-Scholes Model: C0 = S0N(d1) — Xe-rTN(d2)
Where d1 = [ln(S0/X) + (r + σ2/2)T]/ σ √T
And d2 = d1 — σ √T
Theta denotes the current reduction (or rarely increase) in the value of an option per unit of time (usually 1 day). Options with more time left usually have a higher price. An options writer is essentially banking on time decay which is the reduction in the price of an option as time goes on.
Delta measures the change in option price for every unit change in the price of the underlying asset. Options whose strike price is closer to the underlying price typically will exhibit higher deltas.
Delta is a variable and changes according to the price of the underlying asset. The change in Delta is denoted by Gamma. Gamma is a 2nd order derivative that measure the change in the rate of change in price in response to a price movement in the underlying.
Vega tracks the market’s volatility or standard deviation until the time of expiration.
There are different Options Strategies that a trader investor can use to speculate and hedge. Here are a few simple and effective strategies used for trading Options.
Long calls involve buying call options and betting the price of the underlying asset will increase with time.
A covered call is like a short call but with one significant distinction. With a covered call, the trader owns the underlying asset limiting their potential losses significantly.
Long put is similar to long call except the trader will buy puts, betting that the price of the underlying will decrease.
Spread uses two or more options positions of the same class. This strategy combines having a market opinion (speculation) and limiting losses (hedging). Spreads are of different types such as calendar spread or time spread.
Warren buffett famously called derivatives such as options ‘weapons of mass destruction’. As with many other topics, he’s just plain wrong on this one. Options, Futures and other instruments serve as a useful tool to hedge and manage one’s risk and calibrate positions more precisely.
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