What Is an Option?
An option is essentially a right that can be exercised in the future. In order to acquire such a right, the buyer pays a sum and the consideration is called the risk premium. Normally, the right can be the choice to buy or sell an asset at a predetermined price.
In financial terms, an option is a binding contract that allows one party — the buyer — to sell or buy an underlying asset — goods, stocks, indexes, etc. — at a predetermined price within a set time frame. As the buyer of an option contract, he/she has the right, but not the obligation, to buy or sell the underlying asset.
Let us look at a simple example. A fruit store wants to buy 500 kg of apples from an orchard owner, but the apples are not ripe yet and they will not be until August. The fruit store worries about a potential rise in the price since drought is ongoing. Therefore, the store reaches an agreement with the orchard owner to purchase the apples at the price of $4/kg in August — but it does not have to do so if there is some cheaper price on the market. In order to have this right, the fruit store pays the orchard owner $100 as compensation.
The contract above is a typical option. It is called a plain vanilla call option.
(A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a stock.)
The Difference Between Options and Futures.
Many have heard of financial instrument terms like options and futures. There are some similarities between the two. Both are financial derivatives, whose value is reliant upon some underlying assets. They are also both bilateral contracts, with buying (longing) and selling (shorting) parties who can trade them in financial markets. Last but not least, they both can be used as a protective strategy or provide leverages to traders.
However, options and futures are fundamentally different in many aspects.
The transaction object of an options contract is a right, whereas a futures contract is binding on both sides to trade in the future. Therefore, the holder of the options may choose to exercise or stay put at his/her own discretion, while the holder of a future has to perform. This gives rise to some major differences as shown in the comparison above.
The Essentials of Options
1\ Option Buyers and Sellers
Each option contract has two parties, the option buyer/holder and the option seller/writer. The option buyer pays the option premium and is entitled to rights only. The option seller receives the premium as consideration for giving up those rights.
2\ Calls and Puts
Call options (or calls) allow the holder to buy an underlying asset at a certain price.
Put options (or puts) allow the holder to sell an underlying asset at a certain price.
In the specific example above, the fruit store wants to “buy” apples in August, meaning he is buying a call option contract.
Let us now suppose that it is the orchard owner who worries that the apple price may drop in August, and he wants to fix his minimum profit. To do so, he signs a contract with the fruit store, stipulating that he may sell the apples at the price of $4/kg in August, but he does not have to if the market price is higher. This contract is a typical put option contract.
3\ Strike Price
The strike price (or exercise price) of an option is the price at which a put or call option can be exercised. For a call option, the strike price is the price at which the option holders can buy the underlying asset. For a put option, the strike price is the price at which the option holders can sell the underlying asset. It is predetermined in the options contracts.
4\ Expiration Date
The expiration date of an option contract is the last date on which the contract is valid, meaning that the holder has the right to exercise the option according to its terms.
Holders of American-style options may exercise at any time before the option expires, while holders of European-style options may exercise only at expiration.
Exercising an option means putting into effect the right to buy or sell the underlying assets specified in the contract, as opposed to allowing the contract to expire.
Exercising a put option enables the holder to sell the underlying asset at a stated price, and exercising a call option enables the holder to buy the underlying asset at a stated price.
To find out more about the basics of options, please check:
Options on Crypto Assets
In traditional finance, underlying assets vary. There are options on gold, petrol, exchange rates (forex options), stocks, indexes, etc.
If we change the underlying assets to cryptocurrencies, we have crypto-asset options, with BTC and ETH options taking the lion’s share of the market.
The open interest of BTC and ETH all reached their all-time-high in Dec 2020.
However, in 2020, with the rapid growth of DeFi, a number of decentralized options platforms have emerged — think of Hegic, FinNexus, Opyn, Opium, Auctus, etc. — providing decentralized on-chain solutions for trading and settling crypto option contracts.
(Here is an introduction to better understand decentralized options platforms.)
Why Are Options Useful?
Options are both useful and powerful because they can enhance the financial performance of one’s portfolio by boosting income, protection and leverage.
In traditional finance, a good example would be applying options as an effective hedge to limit downside losses. Options can also be used for speculative purposes, such as wagering on the direction of a volatile asset and to generate a recurring income by selling them.
Options Are a Cheap and Easy Way to Appreciate Your Crypto Assets
If one is a hodler of ETH, he/she may easily leverage one’s exposure to 1 ETH by longing ETH calls with a cost of only 0.2 ETH. Also, one can sell/short an ETH put and get an immediate premium, while buying the dips during a price correction.
Options come with leverage, yet due to their structure, traders who buy them do not need to worry about liquidation, since all the buyer pays is the premium which is set in advance. The option holders’ potential loss is capped while the gains can be unlimited.
Options Can Effectively Insure Your Crypto Wealth
By buying puts, one is protected from significant price drops — think for instance about the crash of March 2020 — with a cost as low as a mere 5%. Just as interestingly, option holders can exploit upward momentum if the market price rises over a long period of time since they can choose not to exercise their contracts, unlike with futures.
One could say options are the perfect financial instrument to help you sleep tight at night.
Options Can Be a Good Way to Manage Your Risk Exposure
Controversy surrounds the safety of crypto assets, chiefly because of their high volatility and the risks associated with coding issues. Options can be a great tool to hedge against such risks precisely because they offer unlimited gains, whilst limiting your loss to the relatively small amount you pay to hold the contract.
For option holders, the maximum loss is capped to the option premium, while benefits derived from volatility can be immense, assuming prices move in a favorable direction.
Some Simple Use-Cases of Options
To better understand how options work, here are some simple examples of how to use them either to appreciate or protect your crypto assets.
Holding a Call to Speculate
The long call option strategy is the most basic trading strategy in this field, whereby a user buys call options with the belief that the price of the underlying asset will rise significantly beyond the strike price before the option expiration date.
Sam is an ETH hodler and he is bullish due to the growing DeFi ecosystem on Ethereum. He is holding 1 ETH already. To maximize his gains if the price goes up in the near future, Sam buys 1 ETH call with the strike price of $700 and the expiry of 15 days. The premium is $70 for each contract.
If the price grows by 20% to $840 in two weeks, Sam will get $140 ($840-$700) by exercising the call, and the return is 100% (($140-$70)/$70). The call gives Sam a 5x leverage in return.
If the price drops by 20% to $560 in two weeks, Sam will not exercise the call option and $70 will be all he can lose.
For holding one ETH, Sam may lose only $140 in case of a price collapse.
A Protective Put as an Insurance
A protective put position is created by buying (or owning) an asset and buying put options with a strike price equal or close to the current price of the asset.
Henry is holding ETH and is satisfied with the recent bull run to over $750. While he is concerned that the market may be headed for a correction, he does not want to give up potential profits if the market continues to rise.
To make the most out of this situation, Henry buys put options as insurance, with a strike price of $740. This means that even if the market drops, he still has the right to sell at $740. If the ETH price continues to rise, he can always choose not to excise the puts and ride the bull run.
In this example, Henry is buying puts working as insurance, with which he can sleep tight at night with protections and still enjoy the possible gains.
A Covered Call to Benefit From a Flat Market
A covered call is created by owning an asset and selling an equivalent amount of call options. To execute this strategy, a trader holds a long position in an asset and writes (sells) call options on that same asset to generate an income stream.
Lucy is holding ETH with a price of $750. She expects that the market will stay flat for a while and wants to possibly lower her cost in the flat market. Therefore, she decides to sell ETH calls with the strike price of $760 and earn the premiums of $50 immediately.
If the price gets higher than $760, she will sell when the option buyers exercise the calls. If the price stays lower than $760 till expiration, she will still get premiums and lower the cost of holding one ETH by $50.
In this example, Lucy employs a covered call strategy as she intends to hold the underlying asset for a long time but does not expect an appreciation in price in the short term, and she is satisfied with selling the assets at a predetermined price.
Selling Puts to Buy the Dips
If one writes/sells a put option, that investor is obligated to purchase the underlying assets if the option buyer exercises the option.
Ted is bullish on ETH, and he wants to increase his investment if the market makes any corrections. For instance, assuming the price is $800, he would like to increase his investment if the price returns to $750.
Ted could place orders on exchanges — but it would be even better if he sold a put option with a strike price of $750, thus pocketing an immediate $30 in premium. While if the market actually drops to the target price of $750, he could immediately make a purchase when the option holder exercises.
Selling puts can be a useful strategy for buying the dips at the target price while generating immediate cash flows.
How Do Miners Use Options?
Miners normally have fixed costs to pay and dislike volatility, especially when the prices collapse. Options can be an effective tool to minimize these risks.
John is an ETH miner and expects to mine 100 ETH per month. However, he needs to pay $30,000 for electricity on the fourth of every month. He is concerned that ETH may abruptly drop in value — like it did in March 2020 — which would certainly undermine his profit. Each month, he buys 50 units of ETH put options with a strike price of $600 and an expiry date of one month, to make sure that the monthly electricity bill is covered.
It may cost him $2,000 in total, but the put option works as insurance, and he will still benefit from the ETH upward potential.
A Straddle to Gain From Higher Volatility
A straddle is a strategy that involves holding an equal number of puts and calls with the same strike price and expiration dates. It is a useful strategy to profit from increasing volatility, regardless of the market direction.
Let us imagine that ETH moved up dramatically to $1,000 over the past few days. Alex is not sure ETH is going to go upwards or downwards in the near future. But, he expects that any movement will be a big one and wants to exploit this higher volatility. He can choose to long a straddle by buying a call and a put together with the strike price of $1,000. If the market moves up, the call is there; if the market moves down, the put is there.
It may cost him $120, but as long as ETH either rises above $1,120 or falls below $880, Alex will still end up in profit. The premium of $120 is all he may lose from the strategy.
In other words, Alex may successfully earn profits on a volatile market even if he is not sure where the price is heading.
From the examples above, we may notice that options are very different from both the spot trading market and better-known derivatives like futures or perpetuals. Interesting strategies may be deployed with a flexible combination of options and spot, covering a range of scenarios. Risk-return profiles would vary accordingly.
Options in DeFi
Decentralized options are newcomers in the DeFi space. They were born in 2020, but have great potential and are developing fast. They are non-custodial, open-source, permissionless and interoperable.
Furthermore, the creation of pooled liquidity has solved the problems on-chain where order books could be costly to apply. Please refer to this article for more in-depth reading about decentralized options protocols.
While FinNexus hopes traders will find this article useful, please be aware that options are a multi-faceted and potentially risky product. Before implementing any financial decision please always do your own research first.