Investors typically avoid trading options in cryptocurrency or bitcoin for reasons related to increased volatility compared to equities and general inexperience, but making an option trade in crypto right now is very attractive. It’s important to know what are options in general, as well as how to trade options in bitcoin.
What are options?
Options are derivatives, which means their value is linked to something else – in this case bitcoin. It is a contract that gives you the opportunity (notice I didn’t say you had to) to buy bitcoin at a set price in the future. For example, let’s say I buy an option to purchase bitcoin at $10k. If the price goes above $10k, then I have the opportunity to buy bitcoin at $10k even though the price is higher, but I don’t have to – I could wait until the price is even higher to make a more profitable trade.
There are two types of options:
- Call Option: gives me the option to buy bitcoin at a certain price
- Put Option: gives me the option to sell bitcoin at a certain price
Options have a price, which is referred to as the premium – it’s what I need to pay for the opportunity to execute that trade. Keep in mind that someone is selling you the option contract. In my example of buying a call option to buy bitcoin at $10k I might have to pay $500. This is what entices the person on the other side of the contract to be willing to sell bitcoin at that price knowing there is a risk that bitcoin could go to $20k and they’d still be obligated to sell me bitcoin for $10k.
Without getting into too much detail on option pricing, options will typically be cheaper when the probability of an event occurring is low basically due to the factors of supply and demand.
For example, let’s assume it’s outrageous to assume bitcoin will ever go to $10k: there will be little demand for that option, which forces option sellers to price it lower. In theory, as the probability of bitcoin ever hitting $10k decreases, so will the price of the option. Why would you want to buy the opportunity to execute something that is inconceivable? This probability is measured as the volatility of the market – more volatile markets have a greater probability to to fall or rise sharply.
Important terms for options include:
- Strike Price: Also known as the exercise price, this is the price where an option becomes “in the money”, which is explained below. The strike price is the price where the option holder can buy/sell the underlying asset. For example, you could buy a call option for bitcoin at $10k, but then exercise the option at $12k to book a $2k profit.
- Time to Expiration: This is the last day to trade an option. For example, you can buy a $10k call option on bitcoin that expires January 1st 2019 – the option has no value after that date.
- “In the Money”: In the money or out of the money are two terms that refer to the relationship between the strike price and the current price of the underlying asset. In the money means strike price < current price, so you’re in a profitable position to exercise the option. Out of the money is the reverse where strike price > current price and you’d lose money by exercising.
Another important concept to go over is the concept of “put-call parity”. This is a concept where a trader can hold a short put and a long call to have your risk/reward profile mimic that of holding just the forward asset. That may sound confusing, but the important thing to realize here is you can use this concept to create a risk profile that limits your downside.
This is not entirely accurate but beginners can think of put-call parity as puts and call options “cancelling each other out”. You could sell some bitcoin that you own and buy out of the money call options to have a more favourable risk/reward profile.
For those interested, traditional options are calculated using the Black-Scholes formula, which takes the following variables into consideration: current price, strike price, time to expiration, volatility, and the risk-free interest rate (which is difficult to calculate in crypto – most models will use a base lending rate). Options in crypto are typically overpriced using this model, and it’s important that the ambiguity in the risk-free rate tends to provide wider confidence intervals in the valuations.
Why do traders use options?
A simple answer is to limit risk. Traders can also be profitable in all types of markets (bull or bear). Options trading is incredibly difficult though, and I suggest doing a considerable amount of research before trying it out.
For example, let’s say you own 10 bitcoin at a price of $6500 ($65k total portfolio value) and you want exposure to the upside of the investment, but you also want to protect yourself if the market sharply declines (the price of bitcoin going from $6500 USD to $4500 USD in less than a week). One strategy is to reduce your bitcoin exposure to 5 bitcoin and spend the cash equivalent of one bitcoin to buy bitcoin call options.
There are two outcomes from this position:
1 – Bitcoin falls to $3250 (falls 50%)
You lose 25% of your initial 10 bitcoin position, but your portfolio is 40% cash and your calls will be worth nothing. Your total loss in this situation is 35% of your portfolio rather than 50% of your portfolio (in USD value)
2 – Bitcoin rises
Here, you maintain your upside and may be able to make a 5x multiple on your calls depending on how high the price goes. You maintain your upside.
Options are essentially bets on volatility. Ari Paul, the Chief Investment Officer of Blocktower Capital, is famously misquoted for “predicting” that bitcoin would hit a price of $50k by the end of 2018. Paul bought $50k bitcoin call options at the peak of the market.
Popular news outlets have repeatedly reported that Paul’s purchase was a prediction on bitcoin’s price, and Paul has been criticized for his inaccurate prediction (so far). In reality, Paul was just buying $50k call options to retain his upside while limiting his downside – he was selling bitcoin at its peak value at the same time as buying these calls.
At the time, when bitcoin was highly volatile and it was conceivable that the price could hit $50k, these options were expensive – more than $3k each. These options have lost nearly all of their value now due to the drop in market volatility and the bitcoin price, which is the reason why Paul’s trade is so heavily scrutinized. Paul notes that it was still a profitable trade in the end because he limited his downside risk while maintaining a position in the chance that bitcoin would go parabolic.
Why are options attractive right now in crypto?
There are two main criticisms among traders regarding options in cryptocurrency: the premiums are high and there is low liquidity. The price of premiums are negatively correlated with the volatility of the underlying asset, so when volatility drops the premiums will drop. This is proven by the Black Scholes pricing formula.
Options are attractive right now because they’re incredibly cheap relative to just 6 months ago. Over the past few weeks we’ve seen bitcoin stabilize around $6500 (65% down from its highs), and subsequently in 2018 we’ve seen the volatility of daily returns fall 74%.
To reiterate: buying options right now would be a bet that they are underpriced. If you think bitcoin is currently in a period of abnormally low volatility, and that volatility is bound to pick up, then it could be wise to purchase options. This could be a bet in either direction. For example, you may think that bitcoin could crash to $100 – in this case you could buy out of the money and put options to sell bitcoin at a much higher price in the event of a crash – let’s say $2k.
Here is a chart of bitcoin’s volatility of daily returns in 2018 on a monthly rolling basis:
Where can I buy options?
The most popular sites in crypto to purchase options are Deribit, LedgerX and Bitmex. Most people reading this should not trade options, as it is quite complex. The bid/ask spreads are also much wider than in a traditional orderbook, so poor trades can hurt your overall balance much more.
If you are going to trade options I suggest doing your own research and homework to learn more about them. These trading platforms will have order books, bids and asks, and many other tools that you’ll be familiar with from exchanges like Coinbase and Binance, but the stakes are much higher.
Investopedia has some great resources, and there are some good educational follows on Twitter such as Bambou Club that frequently provide tips on trading options.
This author is invested in cryptocurrencies, including bitcoin which is mentioned in this article.