In addition to Bitcoin futures, Bitcoin options contracts constitute another popular product that both retail and institutional investors seek to trade. In fact, options trading volume has increased from $8 billion in the first quarter of 2020 to $45 billion in the fourth quarter of the year, reaching a total of $77.2 billion in 2020, according to TokenInsight.
As a result, digital asset options play an important role in the crypto space while providing multiple use cases for traders and investors.
What are crypto options?
Options contracts are a type of derivative that represents an agreement between two parties to facilitate a potential transaction on the underlying asset at a predetermined price (called the strike price) before the expiration date.
While derivatives can cover various instruments, for example, stocks, bonds, commodities, currencies and market indices, in the case of cryptocurrency options, the underlying asset is Bitcoin (BTC), Ethereum (ETH) or another digital asset.
Digital asset options and futures contracts are very similar, as both represent agreements between two parties with a cryptocurrency as the underlying asset.
However, while the buyer and seller are obligated to fulfill their commitments in the case of futures, contract holders do not necessarily have to exercise their rights to trade the asset on the expiration date.
Buyers (contract holders) purchase options from writers (sellers) for a premium. Even if the buyer chooses not to exercise their rights, they still have to cover the premium costs.
The premium price depends on multiple factors, including the asset’s value, the strike price, volatility and the contract’s duration.
Increasing volatility levels raise the premium; shorter time periods are cheaper. The reason for the latter is that traders have fewer chances for prices to move in favorable directions over shorter time periods.
Based on broker and crypto exchange offerings, we differentiate two types of options: European and American.
While American options allow holders to exercise their rights at any time before contract completion, their European counterparts are more restrictive.
As with other derivatives, crypto options traders can use leverage to trade and increase their exposure. This could mean amplified gains, but highly leveraged positions also significantly increase their chances of losing the trade.
In addition to greater profit potential, traders can use crypto options to stabilize price fluctuations, hedge against market risk and short sell digital assets.
How do cryptocurrency options work?
You can trade cryptocurrency options in two ways: call and put options.
While call options offer buyers the opportunity to purchase a digital asset at a predetermined strike price, put options allow holders to sell cryptocurrencies at a determined strike price.
Below, we list four example cases for cryptocurrency options trading in the market to understand how they work.
More information on Bitcoin options and other crypto trading products of Binance in: Binance exchange review
Buying a call option
Buying a call option indicates bullish sentiment, as the holder expects the underlying digital asset’s value to increase in the near future.
By purchasing a call option contract, the buyer can protect themselves against high volatility.
For that reason, instead of buying the digital asset in the spot market, the trader covers their position with a call option. As a result, the only risk they are exposed to is the option premium they have to pay to maintain the contract.
In case the underlying asset’s value rises significantly from the strike price at the expiration date, the holder can exercise their rights to obtain profits.
On the other hand, if the cryptocurrency’s value is less than the strike price, the holder can refuse to execute the trade to minimize their losses (although they have to pay the premium cost).
Buying a put option
While buying a call option is a sign of bullish sentiment, the holder believes the underlying asset’s price will fall when buying a put option.
However, unlike shorting the cryptocurrency, the put option holder is protected against a sudden price increase in the digital asset’s value.
In such a case, the put option holder can refrain from executing their contract before the expiration date, recognizing only the premium price as a loss.
On the other hand, buyers will obtain profits when the spot price is below the strike price by an amount greater than the premium paid for the contract.
Selling a put option
Interestingly, traders who predict bullish price changes can also obtain potential profit by selling a put option.
Since put option buyers will choose not to execute the trade when the cryptocurrency’s spot value is higher than the strike price, sellers will benefit from the premium.
However, although the premium offers more profit possibilities for option sellers, unlike buyers, they are obligated to trade the underlying asset when holders decide to exercise their rights before the expiration date.
For that reason, option sellers are not protected against losses like buyers (although they can still make money from premiums).
Selling a call option
Similar to buying a put option, selling a call option also provides traders the opportunity to benefit from bearish price movements.
As with selling a put option, writers here generate profits from the premium when buyers do not exercise their rights to trade the asset.
However, call option sellers will only benefit when the asset’s spot value is less than the strike price.
In the opposite case, they are obligated to execute the trade and realize a loss.
What are the most popular crypto options trading strategies?
One of the main benefits of crypto options is that they provide a high level of flexibility to traders, allowing them to use a wide range of strategies.
Below, we list some of the most popular strategies that traders use for crypto options:
Protective put: Traders use the protective put strategy when they already own the underlying asset. To protect against possible bearish price movements, they buy a put option at the same or similar strike price as the current value of their digital assets. In case the cryptocurrency’s price falls, they can exercise their right to sell the option at the strike price, which will cover most of their losses. On the other hand, if the value of their assets increases, they refrain from executing the trade and realize only the premium as a loss.
Covered call: With a covered call, traders sell a call option while simultaneously holding the digital asset. As a result, they can obtain additional income from premiums during bearish price movements, as buyers will not execute their trades. In the opposite case, the assets they own will cover the losses from selling the call option. That’s why this strategy is called a covered call.
Straddle: Here, traders buy both a call option and a put option with the same strike prices and expiration dates. The move may seem counterproductive at first, as you’re betting on both the decrease and increase of the underlying asset’s price. However, when market volatility is high enough, the straddle strategy allows you to profit from extreme price movements in either direction if the gains from increases or decreases are greater than the total amount spent on premiums.
How do options trades affect the crypto market?
Crypto options trades rarely have a direct impact on the spot prices of underlying cryptocurrencies.
However, large amounts of funds concentrated in out-of-the-money (OTM) options – call options where the strike price is higher than the spot price and put options where the strike price is lower than the spot value – that are close to expiration can suddenly increase market volatility and impact the underlying asset’s price.
If the general market sentiment is optimistic, it means that calls are the dominant forms of options for a cryptocurrency.
During a bullish scenario, market makers (those who provide liquidity on exchanges) may hedge the OTM calls they sell to buyers before expiration by purchasing the underlying asset.
When many OTM options expire in a short period, doing so could create greater volatility and further increase the cryptocurrency’s price.
Crypto options: Useful digital asset derivative products still in early stages
Crypto options are becoming increasingly popular, but they are still in the early stages of adoption, especially if we compare their volumes with digital asset futures.
While the former printed $77.2 billion in trading volume in 2020, futures trading volume amounted to $12.31 trillion in the same period.
Crypto options make the digital asset market more diverse, offering multiple use cases for investors, such as hedging against market risks and increasing potential profits through leveraged trading.
