Trading Bitcoin Options (a primer)

Trading in cryptocurrency options is an underappreciated form of speculation and hedging, mainly because:
a) The steepness of the learning curve when compared to buying and selling spot and futures
b) There are very few places that you can trade bitcoin options

Options are still a relatively unknown product. It is thought that less than 5% of people know how options work.

For those that trade cryptocurrencies already, the spot market and futures markets will be familiar. Options can be useful in building positions that are not achievable by using only futures/spot instruments.

Options can be used to compliment/hedge strategies trading spot/futures or used in isolation.This is a quick primer on Bitcoin Options, a little on understanding what Calls and Puts are and how they translate into profits and loss.

Futures vs Options

Some of the reasons you might buy/sell Bitcoin Options

– When buying Bitcoin Options, your potential loss is limited and your potential profit is unlimited.
– Bitcoin Options allow the user to profit from a falling Bitcoin price.
– Bitcoin Options allow the user to hedge against falling price while HODLing bitcoins.
– If you are a HODLer, the options strategy of ‘selling covered calls’ can provide you with a regular income.
– Bitcoin Options can be used to gain leverage when trading bitcoin. Options allow you to control many times your initial investment.
– Bitcoin Options can be used as a bet on volatility without taking a directional position.
– Buying Bitcoin Options comes with an advantage over futures in that you cannot be liquidated out of your position. – This gives your trade time   to play out if necessary. So if the market initially moves against you, you are still in the game to profit later, if the market moves in your favour.

What is an Options Contract?


An Option is a financial derivative contract on an underlying asset such as a stock, commodity or a cryptocurrency.

Many people think options are a new invention for the age of complex finance. The use of options is known to date back to at least the time of ancient Greece when Aristotle, in his book “Politics”, describes how another philosopher,
Thales of Miletus, profited from an options contract related to his prediction on the following olive harvest.

There are two sides to every option contract, a buyer and a seller. An option contract gives the owner the option the rights (but not the obligation) to either buy or sell the underlying asset at the chosen price (strike price) in the contract at a predetermined date in the future (expiry).

Although trading options contracts has taken place for millennia, their use has been banned in multiple countries around the world at times. The USA, Japan, Europe have all banned options at some point and notably in London,UK, options were banned in the 18th century for over 100 years. The reasons for banning options is due to their perceived riskiness.

Options have a bad image and are seen as highly risky, largely due to their highly leveraged nature. The very thing that draws speculators to them. Options are a huge international market with the options market in total thought to total over $500 trillion.

Options allow market participants to speculate, generate regular income and hedge portfolio positions.

Quick Glossary

Underlying Asset – The asset upon which the Options are based, in our case this is Bitcoin.
Option Type – There are two types of Option, Calls and Puts. Calls give the right to buy at the strike price on expiration, Puts give the right to sell at the strike price on expiration.
Strike Price – The agreed upon price at which the Option (Call or Put) can be exercised at.
Expiry Date – The end of the contract and the date on which the Option is automatically exercised.
Premium (option Price) – The premium is the price paid by the buyer of an Option.
European Style – as opposed to American style options. European style options can only be exercised at the expiry date. Deribit Bitcoin Options are of the European style. Which means that they cannot be exercised until expiration. This doesn’t mean, however, that you need to hold them until expiration, you don’t. You can sell them at any time during the lifetime of the option. Options will be automatically cash settled at expiration.

Cash Settled – In a cash settled option, the writer would pay the holder and profits due in cash rather than transferring the underlying asset (as is often the case with other contracts in many other assets).
Option Chain – Sometimes called the option matrix, the option chain is the dashboard that
displays all of the options contracts that are available, both puts and calls, for the underlying asset. The option chain features all available expiration dates and strike prices.

Risk/Reward Profile for Bitcoin Options

When buying Options, your losses are limited to a fixed amount, unlike Futures contracts. This is what you pay the premium for.

Buyers of options always have a fixed maximum loss. The maximum loss possible for the buyer is the premium that they paid for the option. It is much safer to be a buyer of options rather than a seller. Your risk is well defined. This is a good reason why buying options is seen as more newbie friendly than selling options.
These charts show the profit/loss profile for calls and puts as featured on Deribit. As Deribit uses BTC as collateral, your collateral value rises and falls with the price of BTC in USD. This gives the Deribit options payoff-charts that banana shape where in traditional options, the trajectory of the payoff lines would be straight.

Bitcoin Call Option Payoff Compared to Futures

Bitcoin Call Option Payoff Chart

If BTC price below strike price:

Buyer’s P/L = – Premium
Seller’s P/L = Premium


 

If BTC price above strike price:

Buyer’s P/L = ((Spot Price – Strike Price)/Spot Price) – Premium
Seller’s P/L = Premium – ((Spot Price – Strike Price)/Spot Price)

Bitcoin Put Option Payoff Compared to Futures

Bitcoin Put Option Compared to Futures

If BTC price below strike price:

Buyer’s P/L = ((Strike Price – Spot Price)/(Spot Price) – Premium
Seller’s P/L = ((Strike Price – Spot Price)/Spot Price)


 

If BTC price above strike price:

Buyer’s P/L = – Premium
Seller’s P/L = Premium

What is (ITM) (ATM) (OTM), In the money, At the money and Out of the money?

 

At The Money – When the strike price is at the same (similar) price to the current bitcoin spot price. ATM options are the most sensitive to spot price movements and therefore their Implied Volatility. As there is no intrinsic value to an ATM option (as the strike price is the same as current spot price), its value is entirely extrinsic, coming from its time to
maturity.

In The Money – IN the money options have intrinsic value. For a Call Option to be ITM, its strike price is below the current spot price. For a Put Option to be ITM, its strike price would be above the current spot price.

Out of The Money – An OTM Call has a strike price above the current spot price. It has no intrinsic value, all of the value of an OTM option comes from its premium (extrinsic value).

The Bitcoin Option Chain

Bitcoin Option Chain Deribit

Sometimes called the option matrix, the option chain is the dashboard that displays all of the options contracts that are available, both puts and calls, for the underlying asset. The option chain features all available expiration dates and strike prices.

The option chain is split into two halves. Calls and Puts. Along the left hand side are the expiration dates – sometimes called maturity date. Option contracts make you decide not only what price you want (strike price) but also how long you want for your trading plan to come to fruition.

Most options are not held until the expiration date. They are instead sold back to the market. As lesser time erodes the value of the option, it is risky and not recommended for new option traders to buy an option with less than 30 days left on the contract and to sell the contract well in advance of expiration.

The contracts available are weeklies, monthlies, quarterly and 6-month. The monthlies expire on the 3rd Friday of the month. The weeklies expire every Friday. The monthlies tend to have more liquidity and therefore traders have better chances of moving in and out of a position.

What is Implied Volatility?

IV or Implied Volatility can be a good way to measure wether an option is undervalued or overvalued. It is a mathematically calculated representation of the expected volatility of bitcoin.

If Implied Volatility is high, it would imply that a large move is anticipated/priced into the contract. This relates to a higher premium for the contract and also translates to higher extrinsic value. IV anticipates expected moves but does not anticipate the move’s direction.

If IV is low, it’s generally better to buy options. If IV is high, it is more favourable to sell options.

 

How Does a Bitcoin Option Work?

 

If you are bullish on an asset: Buy a call option

If you are bearish on an asset: Buy a put option

There are two parties to an options contract: the buyer (holder) and the seller (writer). When a holder buys a call option, they will pay a premium to the writer of that option. The buyer now holds the right to BUY the underlying asset at the agreed upon price in the contract, the strike price. A call option becomes more valuable as the price of the underlying asset increases.

Conversely, when a holder buys a put option, they will pay a premium to the writer of that option. The buyer now holds the right to SELL the underlying asset at the agreed upon price in the contract, the strike price. A put option becomes more valuable as the price of the underlying asset decreases.

When you sell an option, you collect the premium (cost of the contract) from the buyer. It is a valid strategy to do this month after month for an underlying asset that you own. However, for the term of the options contract, you forfeit the control of the underlying asset to the holder (buyer).

How to calculate Breakeven point for Bitcoin Option Contract

The breakeven point for an option is NOT the strike price. If it were the strike price, that would mean that the option was free to purchase. The formula to calculate the breakeven is simple and is the same for the buyer and the seller:

Breakeven for a call = Strike Price / (1 — Premium )
Breakeven for a put = Strike Price / (1 + Premium )

It becomes apparent that the amount paid in premium for the option determines the breakeven price. The bigger the premium paid for the option – the further the price need to move for the option to reach the breakeven point (for both sides of the trade).

Example of a Bitcoin Call Option:

Let’s say you buy a call like:

Premium = 0.1 BTC
Strike Price = $8000
Price of BTC at the time of expiration = $10000

You can use the formulas above to calculate what your profit is:
((Spot Price — Strike Price)/Spot Price) — Premium
=((10000–8000)/12000)—0.1=0.2–0.1
=0.1

In this example, the buyer of the call paid 0.1 BTC to buy the option and received 0.2 BTC upon expiry. Leaving the buyer with a 0.1 BTC profit.

Example of a Bitcoin Put Option:

Let’s say you buy a put like:

Premium = 0.1 BTC
Strike Price = $8000
Price of BTC at the time of expiration = $4000

You can use the formulas above to calculate what your profit is:
((Strike Price — Spot Price)/Spot Price) — Premium
=((8000–4000)/4000) — 0.1
=1.0 – 0.1
=0.9

In this example, the buyer of the put paid 0.1 BTC to buy the option and received 1 BTC upon expiry. Leaving the buyer with a 0.9 BTC profit.

Are There Options on Cryptocurrency?


The only other cryptocurrency that you can currently gets options for is Ethereum, also at Deribit.

Where Can I Trade Bitcoin Options?

It is possible to buy and sell bitcoin options at a number of exchanges. Deribit, Quedex, Bakkt, OKEx, LedgerX, IQ Option, IG index and The CME to name a few. By the open interest data Deribit is currently the most liquid and active exchange.

Call To Action

If you’re feeling more curious now about Bitcoin Options and want to try them out, why not head over to Deribit and check it out?

You will get 10% discount for 6 months using this referral code