Essential Things You Need to Know about Bitcoin Options Trading.
Bitcoin (BTC) option is just one term in the crypto space that can easily confuse an amateur trader. But while this term might sound new and complicated to some, the truth is, this financial instrument has existed since the 17th century. In this article, we will discuss the reasons why “option” is a top choice for investors not only in the traditional financial sector but also in the cryptocurrency industry.
Bitcoin Option, a Comprehensive Definition
One of the most popular types of derivative contract, an “option” gives the owner the right to purchase or sell an asset at a specific price, also known as the strike price, within a predetermined date in the future. However, the owner is under no obligation to do so, especially if they are not confident about the status of the market.
Similar to most contracts, an option contract involves two parties –the seller and the buyer. The options contract’s premium, which would be paid by the buyer, is determined by factors such as implied volatility, the current price of the asset against the strike price, and the maturity date.
Using options contracts in the crypto industry has plenty of advantages to investors, particularly to Bitcoin (BTC) enthusiasts. Long-term miners and BTC holders can hedge their market positions and earn extra revenue by writing and selling options. Meanwhile, speculators can minimize the risks while enhancing their exposure for a minimal cost.
It is not a secret that the crypto industry is extremely volatile. However, according to industry experts, the introduction of Bitcoin options had positively impacted the crypto market. In an oft-cited study conducted by the Journal of Finance, the analysts have found out that when an asset is listed in an options contract, it exhibits a decrease in the spread.
Meanwhile, the trading volume and frequency, as well as the transaction size and quoted depth increase. As concluded in the study, option listings enhance the overall market value of the underlying stocks, regardless if the owner takes advantage of the contract or not.
Calls and Puts
There are two forms of an options contract, call and put options.
A call option gives the bearer the right to buy an underlying asset at a specified price. In contrast, a put option gives the holder the right to put an underlying asset on sale at a given price. Mostly, investors can do four things with the options contract. They can buy calls, sell calls, buy puts, and sell puts.
Calls and puts options provide the seller and the buyer the chance to speculate and improve their portfolios. At the simplest explanation, a call buyer profits when the price of the underlying asset is higher than the strike price. At the same time, the put buyer gains revenue when the cost of the underlying asset is less than the strike price.
Furthermore, there are two positions in an option contract –the long and short positions. A long position is established by investors who buy or hold a call or put option. They have the right to buy or sell the asset to a writing investor at a predetermined price.
Meanwhile, a short position is established by investors who write or sell a call and put options. They are under the obligation to sell or buy the underlying asset from the holder of a long position.
Let’s take a more significant look at what market participants can do when using options contracts as well as the position they can take.
The long call
A trader who believes that the price of the underlying asset would increase sometime in the future usually considers purchasing a call option. While it’s possible to buy the asset right away, it would expose them to higher risks, especially if the asset in question is volatile. Buying a call option requires a premium payment, which typically limits the risk the buyer has to take. The potential revenue is determined by the difference between the spot price and the strike price. For instance, if the strike price is $200 and the premium cap is $20, then a spot price of $240 would give the buyer $20 in profit.
The short call
As opposed to the first one, when a trader has a bearish sentiment about the asset’s price, an ideal move is to sell or write a call option. When selling a call option, the writer agrees to sell the asset at the specified price when the buyer decides to exercise their right. When the strike price is higher than the spot price, the buyer will choose not to use their power, and the writer would be able to reap the premium as profit. However, if it goes the other way, and the strike price goes lower than the spot price, then the writer would have no choice but to sell the asset at the agreed price.
The long put
If a trader believes that the price of the asset would fall in the future, then they may decide to purchase a put option. It allows them to sell the stock at the strike price instead of shorting the asset. Just like the strategy in the long call position, the premium payment for the option limits the risk. Buyers will profit if the spot price falls behind the strike price. Let’s say the strike price is 200, and the premium cap was $30, then a spot price of $170 will level the deal, and anything that goes lower than that would represent the revenue.
The short put
An investor who is confident of an upward movement in an asset’s price is likely to use this strategy. They will write a put option and agree to purchase the asset at the specified price once the buyer decides to exercise their right. If the spot price is higher than the strike price of the underlying asset, the buyer would naturally refuse to sell, and the writer of the option gets the premium as profit.
Maximizing earnings through options contract strategies
While options are considered as speculative investments in bullish and bearish markets, well-experienced asset managers take advantage of this financial tool to hedge risks while maximizing potential profits. By effectively combining the basic options trading strategies above, along with the two trades positions, smart and observant investors can tailor a more refined strategy that would further boost their portfolios.
As most successful asset managers often advise, options are more powerful when they are used as part of a more sophisticated strategy. Instead of using them in isolation, veteran traders recommend using them in combination.
When it comes to tailoring options contracts, one of the commonly-used strategies is the one known as the “covered call.” This method allows traders to gain exposure to an asset. While the sentiment is generally bullish, traders do not expect a significant price hike in the near term. To earn a profit, traders would put a call option for sale and reap the payment of premium. Most Bitcoin miners use this method as it allows them a sure gain, and they can even get more in case the price of the crypto increase in the future.
Another strategy that investors use to hedge their long-term investment is known as the “protective put.” However, in contrast with the covered call that limits an investment’s upside in case the buyer of the call option exercise their rights and sell the asset, a protective put aims to hedge the downside while protecting the upside. Traders who use a protective put strategy purchase a put option on a long-term investment to put a cap on potential limits, which in this case is the amount of the put’s premium.
Covered calls, along with protective puts, are just two of the strategies that options contract traders can use. The other methods that can be categorized in terms of market sentiment and foreseen volatility include straddle, butterfly, collar, and strangle strategies, among others.
In the blossoming Bitcoin market, there are also opportunities for arbitrage trading. There exists a principle known as the Put-Call Parity. It states that the difference between a put option and a call option that entails the same strike price and maturity date is equal to the difference between the current spot and strike price, subjected to a discount based on present values.
Here’s the formula: C – P = S – K * D
C stands for the call option value, P for put option value, S for spot price while K represents the strike price, and D stands for the discount price. In case this equation does not apply, traders can instead take advantage of arbitrage trading.
Options Contract Pricing
When it comes to options prices, the market determines the premium based on different factors of intrinsic value and extrinsic value.
Intrinsic value refers to the difference between the spot price of the underlying asset and the given strike price. However, it is only about a positive benefit to the holder of the option. When the buyer believes that an option would not be beneficial, it loses its intrinsic value. The option would just have an extrinsic value, which is represented by the strike price, volatility, and time value.
While there are plenty of other factors and valuation models that can be used as the basis for the calculation of options’ value, there is some candid basis. For instance, if the holder will profit by exercising their right on the option or what we call “in-the-money,” then the contract has intrinsic value. It’s easier to calculate the price of an option whose intrinsic value is already set. In this situation, the extrinsic value would function as the risks associated with volatility and time value.
In contrast, an “out-of-the-money” option lacks the intrinsic value, so the price of the option would be determined based on the extrinsic value factors. The premium serves as a fee that the seller of the option takes in exchange of the risk associated with selling. Bitcoin options, given how volatile this asset can get, usually entail expensive premiums.
Bitcoin options’ promotion and adoption
The past years had witnessed the emergence of platforms and crypto exchanges that offer options trading. The growing number of companies that provide such services had prompted regulatory bodies to put measures and issue compliance guidelines.
As emphasized above, options contracts are vital for the market health of a particular asset. They also play an essential role in terms of boosting or maintaining an individual’s position in a specific market. Furthermore, the options contract is poised to attract more significant investors and companies towards the nascent market.
Globally, several platforms and crypto exchanges are making their respective efforts to meet the guidelines and requirements established by the CFTC. LedgerX and Bakkt are two entities that have successfully acquired the license to operate, and according to reports, the CME Group is close to obtaining the regulator’s approval as well.
Bitcoin options trading platform
The rise of investors’ interest in options contracts has paved the way for the establishment of options trading platforms. Today, traders can choose from a pool of venues wherein they can trade Bitcoin options. The list includes Bakkt, LedgerX, Deribit, Quedex, and the recently added, OKEx.
These trading platforms have their own rules and restrictions. It is a must for traders to evaluate their specific needs before picking one carefully. Fortunately, the financial structure of cryptocurrencies continues to witness significant developments, and smart traders can take advantage of these positive changes to improve performance and boost their portfolios.