In today’s article, CMC Academy dives into the basics of options and explains its types.
In the past year, crypto options have become more mainstream. Although the tool was mostly used by professional traders previously, more retail traders have started to experiment with it now, causing crypto options to rise in popularity as well. In today’s article, CMC Academy dives into the basics of options and explains its types.
What Are Options?
Options are a complicated financial instrument, allowing traders to speculate on the price of an asset. Traders use this tool to bet on the price of an asset on a specific future date, for example, by the end of next week.
Options grant the holder the right to buy or sell the underlying asset at a predetermined price on (or before) the options’ date of expiry; however, they are never obligated to buy or sell the asset.
Now that we have discussed what options are and how they differ from other financial instruments, let’s check the two most prominent types of options: put options (also called puts) and call options (also called calls)!
What Is a Call Option?
Traders buy call options when they believe the market price will exceed the strike price at or before the date of expiry. It pushes the value of the option up, generating decent profits. The more the market price exceeds the strike price, the higher the value of the option becomes.
Let’s have a look at an example!
Lucy buys an Ethereum call option with a $1,700 strike price for next week, at a premium of $30. In other words, she pays $30 for the right to buy Ethereum for 1,700 dollars, next week.
If Ethereum moves to 1,800 before next week, she might decide to close the position before expiry. The option will be worth at least $100, $70 more than what she paid for. In most cases, the option will be worth even more, as people will likely want to speculate on even higher prices, pushing the price of options further.
As you can see, the risk/reward ratio could make buying options a more attractive financial strategy. Of course, there are numerous strategies to make selling options an attractive tool as well, but these are better suited for more experienced options traders.
In addition to buying calls, traders can also choose to sell them before the option hits the strike price if they believe that the underlying price will not make wild moves. The trader will collect the option premium and make money as long as the option does not go above the strike price before expiry.
What Is a Put Option?
A put option grants the holder the right to sell the underlying asset at the strike price on or before the expiry regardless of what happens in the market.
Traders buy call options when they believe the market price will be below the strike price at or before the date of expiry. This will push the value of the option up, generating decent profits. The more the market price will go below the strike price, the higher the value of the option becomes.
As an example, Fred buys an Ethereum put option with a $1,600 strike for next week, at a premium of $110. In other words, he pays $110 for the right to sell Ethereum for 1,600 dollars, next week.
If Ethereum dives to 1,400 before next week, he might decide to close the position early. If he does, the option will be worth at least $200, $90 more than what he paid for it.
Again, when you buy options, your maximum downside is the premium you pay, whereas the upside is virtually unlimited.
This brings us to some of the popular terms linked to the options market. You can find those terms at the end of this article.
Many traders use puts to hedge against the downside. For example, when you hold a significant amount of spot Bitcoins but are expecting a downside in the coming week, you could buy a put option. This will cost you some option premium, but will cover the losses of your spot portfolio if prices do go down.
As with call options, traders can also choose to sell a put option, when the trader expects the price to stay above the strike price of the option. So long as the price trades above the strike price of the put option, the seller will get to keep the premium.
But wait, there is a little more to it!
So far, we have explained the basics of buying and selling options. However, option prices move differently than the price of the underlying asset. Bitcoin spot prices and Bitcoin options are usually not correlated on a 1:1 basis.
Traders use these greeks as points of information to make trading decisions.
In short, options can be used to bet on the direction and reduce the risk of a portfolio, but also to speculate on sideways price action.
As promised, here is a glossary of options trading terms: