Bitcoin Options, Explained
What is a Bitcoin option?
An “option” is a type of derivative contract that gives the owner the option (not the obligation) to buy or sell an asset at a specified price (the strike price) within a predetermined time (the expiry date).
While the term “derivative contract” typically conjures ideas of complicated financial instruments cooked up in Wall Street labs, contracts similar to options have been in use since at least ancient Greece to speculate on the olive harvest, and they span across cultures, exemplified by the 17th century Japanese “Dojima Rice Exchange.” Today, options contribute to a global derivatives market estimated to be over $500 trillion. So, why are options such a long-standing and massive staple in finance, and what does the rise of Bitcoin (BTC) options mean for crypto?
At an individual level, options allow market participants to generate income, make speculative bets, and hedge their positions, particularly amid market volatility. In an option contract, there is a “writer,” or seller, of the option and a buyer. The buyer pays a premium for the options contract determined by factors including moneyness (the asset’s current price vs. the strike price), time to expiry, and implied volatility; the writer then takes that premium as income.
When applied to Bitcoin, this has huge benefits for many players in the ecosystem: Long-term hodlers and miners can effectively hedge their positions and earn income by selling options, and speculators can limit downside risks and get upside exposure for a fraction of the cost.
Looking at the market as a whole, options have also been shown to be critical for market health. According to an oft-cited empirical analysis by the Journal of Finance, options listings for an asset lead to “a decrease in the spread and increases in quoted depth, trading volume, trading frequency, and transaction size” and, overall, results suggest “that option listings improve the market quality of the underlying stocks.” In other words, Bitcoin options can benefit the entire ecosystem, whether a specific individual uses them or not.
Option basics: Buying and writing, calls and puts
Options contracts come in two forms: call and put options. Call options give the buyer the option to purchase an underlying asset at a given strike price, while a put option gives the buyer the option to sell an underlying asset at a given strike price.
Calls and puts provide the basic levers for writers and buyers of options to speculate and/or hedge their portfolio. At the most basic level, the buyer of a call profits when the underlying asset price is greater than the strike price, and the buyer of a put profits when the underlying price is less than the strike price. But let’s take a deeper look at how each contract functions for each market participant:
The Long Call –– POV: Buying a call option, Sentiment: Bullish
A trader who buys a call option believes the underlying asset’s price is going to increase. While traders could simply buy the asset outright, they then have direct exposure to the asset’s price risk up to its entire principal –– this is especially risky with a volatile asset class. When buying a call, however, the risk is capped at the premium paid to purchase the option. The potential profit, however, is determined by the amount the spot price is over the strike price plus the premium. For example, if the strike price is $100 and the premium paid is $10, then a spot price of $120 would lead to a profit of $10.
The Short Put –– POV: Writing a Put Option, Sentiment: Bullish
Another option for traders who believe an asset price will increase is to write/sell a put option. When selling a put option, traders agree to buy the underlying asset at the strike price if the buyers choose to exercise their right to sell. If the spot price of the asset is greater than the strike price, buyers will choose not to sell, and the option writer will profit from the premium.
The Long Put –– POV: Buying a Put Option, Sentiment: Bearish
If traders are bearish on the asset in question, they may choose to buy a put option, giving them the option to sell at the strike price, as opposed to shorting the stock. Similarly to the Long Call above, this limits the risk of loss to the premium paid for the option. When buying a put option, buyers will profit if the spot price is below the strike price by greater than the premium paid. For example, if the strike price is $100, and the premium paid was $10, then a spot price of $90 will break even, and anything lower will profit.
The Short Call –– POV: Writing a Call Option, Sentiment: Bearish
The other option for traders predicting a decrease in price is to write/sell a call option. When writing a call option, traders agree to sell the underlying asset at the strike price if buyers exercise their right to buy. Similar to the Short Put above, this strategy aims to collect the premium on the option, while buyers choose not to exercise their option; this occurs when the spot price is lower than the strike price. If the spot price is higher than the strike price, the writer of the call will have to sell the asset at a discount.
This strategy is commonly used as part of a covered call strategy, as explained below.
Options trading strategies: How to profit in bear and bull markets
While options can be used as purely speculative investments, the most successful asset managers use options as a way to effectively mitigate risk and maximize potential earnings. By combining the four basic options trades (listed above) with the two basic stock trades (long and short), investors can create a range of more sophisticated strategies to optimize their portfolios.
The true power of options is not in their isolation, but when they act as part of a broader strategy. When used in combination, they can tailor an investor’s exposure to a very specific risk profile, limit losses, generate income and create more predictable returns.
As mentioned above, one of the most popular options strategies is the Covered Call. In this strategy, investors have exposure to an asset and are bullish long-term but do not predict a significant increase in price in the near term. To allow the asset to still generate a return, traders sell a call option on the asset, thereby receiving a return in the form of a premium. This is likely to be a popular strategy, as we have already seen Bitcoin miners using futures to hedge their production. Now, miners can sell a $300 call option with a strike price of $10,000, allowing them to earn yield while still making a profit in the event of a price increase.
A similar strategy to hedge a long-term investment is a simple Protective Put. Unlike a covered call, which limits the upside of an investment if the call option is exercised and the asset sold, a protective put seeks to limit downside while preserving the upside. In this case, traders buy a put option on a long-term investment to hedge against potential losses, with a limit on upside equal only to the put’s premium. If investors have been increasing exposure during this recent bear run with predictions of a rally, they may want to purchase a protective put for $200 at a $6,500 strike price, limiting their downside.
Covered calls and protective puts are only the beginning of the options-strategy rabbit hole. There are collar strategies, straddle strategies, strangle strategies, butterfly strategies and more. They can be grouped in terms of market sentiment — bullish, bearish or neutral — and predicted volatility.
Particularly in these nascent market stages for Bitcoin options, there are also likely to be arbitrage trading opportunities, according to the Put-Call Parity principle. This principle states that the difference between a call and a put option of the same expiry and strike price is equivalent to the difference in the current spot price and strike price, discounted to present values.
C - P = S - K * D
Where C = call option value, P = put option value, S = spot price, K = strike price and D = discount factor.
When this equation does not hold true, there exists an arbitrage opportunity for traders to capture –– especially in the early days of these options markets.
The basics of option prices: Why are Bitcoin options so expensive?
The price of options (known as the premium) is determined by the market and is based on factors of intrinsic and extrinsic value. Intrinsic value is the difference between the underlying asset spot price and the strike price but only in reference to a positive value to the option holder. When an option is not beneficial to the buyer, it is said to have zero intrinsic value and only extrinsic value, such as time value, strike price and volatility.
While there are a number of factors and highly complex valuation models that are employed to calculate the value of various options, some of the basics are pretty straight-forward. When an option is “in-the-money,” which means holders of the option will benefit by exercising their option, then the option has intrinsic value. An in-the-money option is easier to value, as the intrinsic value is set, and the extrinsic value is a function of the risk associated with time value and volatility.
An out-of-the-money option, on the other hand, has no intrinsic value, so its price is entirely dependent upon those extrinsic value factors. The premium, the price of the option, is like a fee that the writer of the option takes for the risk of selling. It should come as no surprise, then, that an asset as volatile as Bitcoin has such expensive premiums.
Acceptance and recent developments
Within the past year, additional options trading platforms and exchanges have emerged along with some regulatory clarity.
As mentioned above, options are critical for the health of an asset’s market and the management of an individual’s position in that market. Such instruments are also critical to attracting larger, more sophisticated investors and institutions.
Several platforms globally are rising to meet the demand of traders for options, and even the CFTC is seemingly on-board with regulatory approval given to LedgerX and Bakkt, with CME Group coming soon.