In today’s article, CMC Academy dives into the basics of options and explains its types.
Don't have time to read? Check our video instead! ⬇️
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.
The predetermined price is called the strike price, whereas the price you pay for the option is called the option premium.
Currently, the most popular assets in the crypto options market are Bitcoin and Ethereum. However, the market for altcoin options is growing as well. Some traders use these options to speculate on the direction and volatility of these assets, while others use them as a hedging instrument. Contrary to most other instruments, options can provide good trading opportunities even if the market is not making wild swings.
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?
A call option grants the holder the right to buy the underlying asset at the strike price on (or before) expiry, regardless of what happens in the market.
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.
If the price moves against Lucy’s trade, the option will expire, incurring a loss of $30 for Lucy. In other words, when you buy options, the downside is limited to the premium you pay, whereas the upside is virtually unlimited.
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.
This is because of the option greeks. There are a number of greeks, each more complicated than the other.
Today’s article only discusses the basic ones. Firstly, Delta(Δ): the rate at which the option value moves relative to the move of the underlying asset. For example, a Bitcoin option with a Delta of 0.73 will move by 0.73% for every 1% move on Bitcoin. This will help you understand how the option will behave if volatility hits the markets.
Another unique factor in options is how they lose a little bit of their value as they move closer to expiry. Options see their value decay because there is less time for the trader to make a profit. This decay in value is expressed in Theta (θ): the rate at which the premium of an option declines near its expiration.
Traders use these greeks as points of information to make trading decisions.
Wrapping Up
We can understand you may be feeling overwhelmed after reading this article. Trading options can be confusing as there is far more to it than futures. Nevertheless, options open new opportunities that are not found elsewhere in the market. It takes time to understand options and to figure out how to use them to your advantage.
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:
Call option: The right to buy the underlying asset at a pre-set price at, or before, expiration.
Put option: The right to sell the underlying asset at a pre-set price at, or before, expiration.
Option Premium: The price paid for an option or the current value of the option.
Delta: The rate at which the option value moves relative to the price of the underlying asset.
Theta: The rate at which the value/premium of an option declines over time near the expiration.
Gamma: The rate of change between the delta and the asset’s price.
In the Money: When the value of the underlying asset is higher than the strike price of a call or lower than the strike price of a put option.
At the Money: When the value of the underlying asset is equal to the strike price of an option.
Out of the Money: When the value of the underlying asset is lower than the strike price of a call or higher than the strike price of a put option.
Expiration: The date when the option settles.
This article contains links to third-party websites or other content for information purposes only (“Third-Party Sites”). The Third-Party Sites are not under the control of CoinMarketCap, and CoinMarketCap is not responsible for the content of any Third-Party Site, including without limitation any link contained in a Third-Party Site, or any changes or updates to a Third-Party Site. CoinMarketCap is providing these links to you only as a convenience, and the inclusion of any link does not imply endorsement, approval or recommendation by CoinMarketCap of the site or any association with its operators. This article is intended to be used and must be used for informational purposes only. It is important to do your own research and analysis before making any material decisions related to any of the products or services described. This article is not intended as, and shall not be construed as, financial advice. The views and opinions expressed in this article are the author’s [company’s] own and do not necessarily reflect those of CoinMarketCap. CoinMarketCap is not responsible for the success or authenticity of any project, we aim to act as a neutral informational resource for end-users.
