Understanding Options Trading in Cryptocurrency

Not all options carry the same risk, and understanding them is crucial. If you are the holder (buyer), your risk is different from if you are the writer (seller).

 

Key Takeaways

  • Option contract provides its holder the right to buy or sell, but it is not an obligation.

  • American style options can exercise the contract anytime before or at the expiry date, while European style options can only exercise the contract at the expiry date.

  • In the money (ITM) option contracts cost more than At the Money (ATM) or Out of the Money (OTM) option contracts because they already have intrinsic value.

Introduction

An option is a financial instrument, a derivative, that derives its value based on an underlying asset such as stocks or cryptocurrencies. The official date for trading options began in 1973, but there is evidence that it has been around for hundreds of years and dates back to 350 B.C.


An option contract provides its holder the right, but not the obligation, to buy or sell at a specific price of an underlying asset on the expiration date.

Understanding Options Trading in Cryptocurrencies

How do Crypto Options work

Crypto options might look complex at first, but with this guide, you can grasp the basics of trading your first crypto option.


Styles

Exercising an option happens when the contract holder decides to exercise their right to buy or sell the underlying cryptocurrency at the predetermined price, also known as "strike price," before or on the predefined date.

  1. American - can exercise the contract anytime before or at the expiry date.

  2. European - can only exercise the contract at the date of expiry.


Types

The type of options you purchase would determine whether you have the right to buy or sell the underlying asset in the future. We can simplify it to:

  1. Call Options - gives the right to buy the underlying cryptocurrency.

  2. Put Options - gives the right to sell the underlying cryptocurrency.

Option Trading Process


  1. An options seller "writes" (creates) a call or put option contract with detail of the expiration date and a strike price.

  2. The options seller would then proceed to a crypto options exchange to list their contracts or sell their contract to buyers that have already placed their orders.

  3. The buyer pays the seller the cost of the option, usually referred to as a "premium."

  4. The premium is calculated based on the remaining time on the contract, interest rates, the current price of the underlying asset, and the implied volatility (the expected standard deviation of the underlying asset's price between the start and end dates of the contract).

The most critical factor for the premium cost is the underlying asset's current price.

  • In the money (ITM): When the strike price of a call is lower than the underlying asset's current price. For a put, it is when the strike price is above the current price.

  • At the money (ATM): It is when the strike price of a call or put is equal to the current price.

  • Out of the money (OTM): When the strike price of a call is higher than the underlying asset's current price. For a put, it is when the strike price is less than the current price.

ITM contracts cost more than ATM and OTM contracts because they already have intrinsic value. Naturally, this does not guarantee that the price will remain above the strike price until the contract expires.


Risk of Crypto Options

Not all options carry the same risk, and understanding them is crucial. If you are the holder (buyer), your risk is different from if you are the writer (seller).


Buying Calls: The upside potential is limitless, and the downside potential is limited to the premium you paid. You want the price to skyrocket so you can buy it at a lower cost.


Buying Puts: The upside potential of a put is the difference between the strike price and the current price (for example, if you buy the right to sell at $40,000 per BTC and the price drops to $30,000 per BTC). The downside possibility is the premium you paid. You want the price to fall dramatically so you can sell it at a "higher" price.


Selling Calls: When you sell a call, you essentially sell the right to buy to someone else. The upside potential is limited to the premium for the option. The downside potential is unlimited. You want the price to remain stable (or even fall slightly) so that whoever buys your call does not exercise the option.


Selling Puts: When you sell a put, you are selling the right to sell to someone else. The premium for the option again is the upside potential. The downside potential is the difference between the strike price and the current price. You want the price to remain above the strike price so that the buyer does not force you to sell for more than the crypto is worth.


Should you try Crypto Options?

Crypto options can be utilized as a tool to generate income, hedging, or speculation. Of course, every investment involves some level of risk, and it is up to the investors to manage their own risk. If you manage your risk well, the crypto option can be an excellent investment to add to your portfolio.