Your Guide to Cryptocurrency Options
Market Meditations | December 15, 2020
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.
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.