Your Guide to Cryptocurrency Options

Market Meditations | December 14, 2020

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Your Guide to Cryptocurrency Options

Bitcoin options are the fastest growing crypto derivatives product with total open interest up 1000% this year, yet remain ‘niche’ and something barely touched upon by mainstream news outlets. The average investor thinks of options as being too complicated, but given the recent and expected further growth, a basic understanding of these products can be another useful tool in the cryptotrader’s toolbox. In today’s article, I give an overview of options. After the basics are covered, we take a look at why options saw exponential growth this year and how it can be a useful instrument for this market.

Options 101

So let us begin with what options are. They are not complicated and there is no reason a crypto trader should shy away from them. Allow me to guide you through them and explain why they can be an attractive alternative trading strategy. The basics:

  • Instrument types. There are two main types of contracts when it comes to options trading: calls and puts. A call option gives the buyer of the option the right, but not the obligation, to buy an asset at a specified price (“strike”). A put option gives the buyer the right, but not the obligation to sell an asset at a specified price. 

  • Premium. Of course, having the right to buy or sell an asset at a specified price isn’t free. The “premium” is the price the buyer pays for that right. 

  • Expiration date. What it says on the tin. The date at which the option expires, and the buyer of the option has to choose between exercising the option or not. 

Everything is easier to explain in practice, so let’s draw up not one but two examples. Options in legacy markets and options in crypto markets. 

Sahil Bloom gave an intuitive example of a possible call option earlier this year. Let’s say you are bullish on a house. It has a fantastic back garden and one of those nice old fireplaces. You are pretty sure it’s going to appreciate in value. Is being pretty sure enough to place $1m on purchasing the house? Maybe not. Good thing you have other options. You pay the owner $50k today for the right to buy the house before Dec 31 at $1m. 

Here’s where the magic happens. The outcomes are binary. The house either appreciates in value or depreciates in value.

Scenario 1: As you expected, the house appreciates in value to $1.2 million. You locked in the right to buy at $1m with your option. Buy at $1m and sell at $1.2m. What’s your profit? $200k minus the premium: $150k. 

Scenario 2: The housing market is unpredictable and the house depreciates to £0.8 million. However, your loss is the premium: $50k. Even if the house price drops to $0, your loss is the premium. Your loss can only ever be the premium.

We spoke about the housing market here but the exact same principle applies to cryptocurrencies. A trader may wish to buy a call option if they believe the price is going to move higher or a put option if they believe the price is going to move lower.

In an extensive thread earlier this year, options specialist Tony Stewart expanded on why options are so popular: “Options allow market participants to express views with an affordable outlay premium, flexibility, leverage and to an option buyer, less risk.” This is because when options are bought, they have limited downside (the premium) but unlimited upside. Keep in mind, selling options can be riskier and if you don’t own the underlying asset, your losses are potentially unlimited. This goes without saying, but do not start trading options if you do not understand the risks. Take this article as a starter, not a main course. Options traders are known to show their big ROI % ‘s but as is true of anything with high reward, there is also high risk. 

This Year’s Exponential Growth

Given the pros of trading options that we have mentioned and the ease at which traders can get started, it is not surprising that trading cryptocurrency options has grown in popularity. Open interest in options for both BTC and ETH saw exponential growth this year. According to The Block, options trade volume growth outperformed futures trade volume growth by about 5.4 times with the ETH options being the biggest gainer after a record month in November. Monthly trade volume for ETH was $1.76 billion, up 153% compared to October and strongly above previous highs in August. 

Although all trading products saw an increase in volume this year, the rise in options volume might be a sign that the market is maturing and institutional traders and investors, so-called ‘smart-money’, are becoming more comfortable trading this exotic and volatile market.

So why sit out and let others have all the fun? Having got to this point of the article, you should have the information and resources to take a further look at trading cryptocurrency options. Do your research, explore the art of the possible and good luck. 

  • ECB Governing Council Highlights Potential for ‘New Business Models’ if a Digital Euro Is Introduced. Although no final decision had been made about whether Europe will move forward with a digital Euro, a new statement from the ECB leadership indicates that the institution is considering the potential market implications of such a move. This does not, however, imply any intention to crowd out the private sector’s role in providing payment services.’ Earlier reports on the creation of a digital Euro speculated that a decision could be made as early as January. Read more.

  • Microstrategy Announces Completion of $650 Million Debt Offering to Fund Bitcoin Buys. With a tweet on Friday, MicroStrategy CEO Michael Saylor announced that the firm completed their $650 Million offering of 0.750% convertible senior notes due 2025. The amount is $100 million higher than expected and as The Block reported last week, “it remains to be seen how much of the intended issuance will be completed or whether this method of purchasing bitcoin via debt issuance would lead to any pushback from the U.S. SEC. Read more.

  • Fidelity’s Bitcoin Custody Business Has Been ‘Incredibly Successful’. CEO of Fidelity Investments Abby Johnson said that the mutual fund’s enormous custody business regarding bitcoin has been very successful. Abigail said that the firm is putting a lot of effort into connecting the legacy world with the future of digital currencies. “Building those on and off ramps around facilitating the trading between fiat currencies and cryptocurrencies is something that’s happening now, and I’m glad it’s moving along” she said. Fidelity began offering bitcoin custody services in March 2019 through a separate arm called Fidelity Digital Assets. Read more.

  • MassMutual Bitcoin purchase proves crypto demand is rising, JPMorgan says. MassMutual is the latest fish in a sea of investors looking to grow their crypto exposure. MassMutual’s $100 million Bitcoin (BTC) purchase shows that the demand for cryptocurrency will be growing further, according to strategists at major investment bank JPMorgan. In an investor note on Dec. 11, JPMorgan strategies reportedly suggested that Bitcoin adoption is now expanding from family offices and wealthy investors to the likes of insurance firms and pension funds.. Read more.

Dec 15, Tuesday:

  • Orion Protocol (ORN) mainnet phase 1:
    Mainnet launches are generally considered to be a fundamentally bullish event. According to the launch webpage, this is only the first phase and “our full, widespread launch will be available for anyone to use very early in Q1.” 

Dec 16, Wednesday: 

  • Aion hardfork:
    On December 16th we will be rolling out a mandatory hardfork to the Aion Network. This hardfork includes updates and improvements to resolve issues that the network has been facing as well as improve performance.

  • FOMC meeting: 
    At U.S. federal reserve meetings, plans to purchase longer-dated Treasures to keep yields contained are announced. In English, we will understand whether the U.S. plans to support the economy by increasing the money supply and of course, this has inflationary consequences which impacts the level of desirability of cryptocurrencies.

Dec 18, Friday: 

  • Conceal (CCX) halving:
    A decrease in mining block rewards means decreasing inflation and thus less supply that gets sold on the market. If demand stays constant, this could drive price upwards in the long-run as we saw with bitcoin this year. “Conceal Network mining block reward will effectively be cut in half to 6 $CCX per block and remain fixed. #Halving is planned for December 18, 2020.”

  • Tesla joins S&P 500: 
    Tesla joins the S&P 500 on Dec. 21 and investors anticipate an epic trade of over $50 billion of Tesla’s shares in the minutes before Friday’s close.

The Art of Trading a Losing Position

You are long a coin and it is losing value. You think you want to sell it. But, do you sell it now? Will there be further losses? Or will the price go back up again? All you know is you want to preserve your capital. In an ideal world, you would always be able to achieve this aim by selling at the right time. 

Of course, it’s easier said than done. If we all always sold at the right time, there would be a lot more billionaires out there. Anyways, you only have to look to the past to see how difficult this really is. 

Think back to 2007. I say 2007, you think the U.S. housing crisis. Bingo. When the markets started crashing, getting more and more bearish, most traders and investors had no idea what to do. In fact, many didn’t even react until the value of their portfolio had crashed by as much as 50-60%. So what do you think was on their minds? Easy: “I will wait until the stocks come back up. I know there is a lot going on in the economy right now so I will stay conservative and just wait until I break even”. Ah, the good old breakeven philosophy

Traders. It is amazing how many people forget basic mathematics when it comes to breaking even. Let’s put aside for a second the hard truth that there is zero guarantee the asset will ever come back, let’s just look at some numbers: 

It’s back in 2016 and bitcoin is trading at $500. You are long. Imagine the value declines 50% to $250. Well, when you are waiting to ‘break even’ you are not just waiting for the coin to reverse its price drop return to its original value. For $250, to get back to $500, you are waiting for an 100% increase. 

Many traders forget this simple mathematics and take really big losses. And all the while you are waiting for this break even, you could be using the tied up money in other (winning) trades.

This is where a pre-defined trading strategy comes in. At the time of planning, you can think clearly about why you would want to sell a hypothetical position. You have no emotional attachment before you enter a position, so you are able to think rationally. When we don’t have a plan and we start to experience losses we can find emotions such as fear or greed take over. These can lead us to ‘wait’ to break even in scenarios where it is not sensible to do so. If you have a pre-defined trading strategy, one would hope you know why you bought the coin. So, when you want to sell, you ask yourself 3 questions:

1) Why did I buy the coin?
2) What has changed?
3) Does the change undermine my original reason for buying the coin?

So the first question should be easy. For the second one, you need to know what has created the decline in price. Was it a fundamental reason? Has a key technical level been broken? You then need to compare this reason with reason 1 and if it means reason 1 is no longer valid, it’s time to call it a day and sell. If you revert to your initial reasons for entering the trade, you will not be emotionally attached and your ability to make smart selling decisions will improve significantly over time. 

Regular readers of the Market Meditators will notice the theme: the best traders don’t allow emotions to influence their trading decisions. In today’s letter, we have introduced you to yet another way to control your emotions when it comes to trading. Read, learn, enjoy and start tomorrow as a better trader.

Disclaimer: The content in this newsletter is for informational purposes only. Nothing in this email is intended to serve as financial advice. I am not a financial advisor. Every investment and trading move involves risk. Do your own research when making a decision.