As cryptocurrency gains popularity, the need for more advanced trading contracts grows. Options and futures trading are sophisticated products of the traditional financial spaces that have become popular in cryptocurrency markets.
Options trading is a derivative contract that bases its value upon an underlying financial asset like bonds, commodities, currencies, or stocks. Consider derivatives as secondary assets whose value is affected by the performance of the primary security. Options trading in cryptocurrency follows the same pattern as with the traditional market. The value of the option contract depends on the price of the cryptocurrency.
Like every other derivative product, you may see options trading as a risk management technique or a speculation strategy with the expectation of commensurate returns. Here are five ways to position yourself for opportunities as a trader.
1. Understand How Crypto Options Trading Work
A crypto options contract gives a holder the right, but not the obligation, to buy or sell a cryptocurrency at an agreed-upon price and date. For every options trade, there is a premium payment. This premium refers to the price a buyer pays to a seller for an option contract. Two types of options exist: the call and put options.
- A call option is a bet that the price of an underlying asset will rise.
- A put option is a bet that the price of an underlying asset will fall.
2. Choose the Best Crypto Options
A crypto option is not a risk-free trading strategy. It is also a game of chance where you earn when your predictions are correct. It is essential to understand the risks involved in options trading. Unlike futures trade, where buying and selling pose an equal risk, in options, however, the risk-to-reward for a buyer is quite different from that of a seller.
Buying or selling, which poses a greater risk?
The price of bitcoin in April was $44,000. As an investor, you believe the price will be much higher by the end of May. You bought 1 European-style call options at a strike price of $47,000 for a 0.015 bitcoin premium per contract, which expires on May 31.
Your premium price was $660 (0.015 bitcoin at $44,000).
Each contract gives you the right to purchase 1 bitcoin at $47,000 per coin. So you can buy one bitcoin for $47,000 when the contract expires at the end of May.
Case One from the buyer’s perspective:
Upon expiry, bitcoin rose to $50,000. You exercised your call option and made $3,000 profit (50,000-47,000=3,000). Your total take-home is $2,340, excluding the premium you paid.
However, the seller of this call option incurs the $2,340 ($47,000-$50,000+$660) loss because he must sell bitcoin to you at $47,000, though the market price for bitcoin is $50,000.
Upon expiry, bitcoin dropped to $40,500. You chose not to exercise this call option because your prediction has gone wrong. You lost $660, the price you paid for the call premium.
3. Hedging to Offset Loss
When a news item or a tweet from Elon Musk spikes a short-term rally, you may hedge the rising prices instead of closing your short-trade and reopening it.
Hedging involves opening a crypto option position to offset the risk to an existing trade to create a net-zero effect or profit. You do this by entering a new crypto trading position opposite your losing trade to sell the same cryptocurrency to prevent downside risk.
Hedging example culled from ig.com:
A trader is holding 1 unit of short index position at $5,800. To hedge it, he bought a call option with a strike price of $5,800. The cost of the option (option premium) was $20.
The underlying price rose to $6,000. His short position would have lost him $200 ($6,000-$5,800). However, his option is in the money by $200. Subtracting the premium, he will have a profit of $180 from the option. Compared to a naked short index position, the hedged position (short index + long call option) caps his loss to $20 (the option premium) when market goes against him.
The trader can still profit from his short index position should the market drops below $5,800, as the option will expire worthless and will not be exercised.
4. Know Your Risk to Reward Ratio
Before hedging with crypto options, consider the price of the trade premium. If the cost of opening the position eradicates the returns you could make on your hedge, it’s not worth doing. See example one above. If the premium price was much higher, say 0.06 per bitcoin, five contracts will cost you $2640. You will be at a loss at the expiry.
If, however, you could pay the premium and still have a net-zero balance or even generate a profit, then it’s a strategy worth considering. Remember that your risk is limited to the premium you paid when buying a call or put option. But as a crypto options seller, you take on a much higher level of risk. For instance, you face unlimited potential loss if you write an uncovered call since there is no cap on how high a cryptocurrency price can rise.
5. Alternative Trading
Most options investors’ strategies have limited risk and limited profit potential. Options strategies are not get-rich-quick schemes. Beware, it’s possible to lose your entire capital or even more. For all trading activities, invest just what you afford to lose.
So when the loss comes, you won’t go emotional trying to salvage the trade, thereby exposing more of your funds to danger. Instead of speculating on the price of an underlying cryptocurrency, you may buy the asset itself.
This article should not be taken as financial or investment advice. Making an investment or financial decision is a choice. Do your research!
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