In a volatile market, crypto options can be used to help reduce risk in trading portfolios.
Sophisticated options strategies have potential to protect traders from 'catching knives' in attempts to time market bottoms.
Intro to crypto options trading
Crypto options trading can be confusing, especially in a sea of derivatives. But for traders looking to hedge risk on a long or short trade, this derivative is a powerful tool.
The mechanics of options trading are similar in both the stock and crypto markets. In this guide, you'll learn how crypto options trading works and the benefits and risks of popular strategies.
Options trading definition
A stock or crypto option is a contract that gives you the right but not the obligation to buy or sell an asset at a specific price. American options provide that right within a given timeframe and European options can only be exercised on a specific expiration date.
Call option contract: The right to buy
Put option contract: The right to sell
Options trading is how investors buy and sell these contracts in an open market. Since there isn't an obligation to buy or sell, this type of trade is fundamentally a way to reduce risk.
That is not to say every option trade is risk-averse. With options trading strategies, you either pay someone to take on risk for you, or you can get paid to take on someone else's risk. They also allow you to speculate on the future price of an asset while hedging your potential losses.
Options trading in crypto markets
Bit.com is one of the leading crypto options markets. They offer BTC, ETH, and BCH options and attract both institutional and retail investors.
So far, the most popular option pairs are BTC and ETH. Bit.com pioneered BCH pairs in 2021, and Deribit introduced SOL pairs in 2022. Crypto options proponents believe that the market should adopt more mainstream pairs to provide ample hedging and investment opportunities.
How crypto options differ from traditional markets
There are minor differences between crypto and stock options trading. First, crypto markets are open 24/7, unlike stock markets, which close on the weekends and at 4 pm EST on weekdays.
Another difference is premiums. Because implied volatility is essential in pricing options, crypto options can be costly. On the other hand, higher volatility can increase profit potential. One trader saw a paper profit of more than $4 million on a $638,400 trade back in 2020.
Inversed vs. USD-denominated options
Inversed options are quoted in the token whilst USD-denominated quoted in stablecoins. Due to the legacy reasons in the crypto space, most of the existing options are offered as inversed options. To allow more investors to participate in crypto options trading, Bit.com has told Blockworks it will offer USD-denominated options in July 2022. USD-denominated options are more straightforward in understanding option premium and calculating the PnL, especially in the Unified Margin system, where all assets are calculated as collateral in its USD value in a haircut ratio.
Bit.com believes that USD-denominated options will provide users more access to crypto options trading as it is easier to calculate altcoin option price.
A call option is a contract that gives you the right to buy a digital asset at a specific price.
Let's say the price of BTC is $30,000, but you think it will go up in the next month. On Bit.com you could buy a call option for one bitcoin at a strike price of $35,000. We'll say the premium is $400, and the contract expires at the end of the month. Now imagine the price of BTC surged to $37,000. By exercising your call option, you would buy at a discount of $1,600 (BTC's price, minus the strike price, minus your option premium). You wouldn't profit $1,600 unless you also sold BTC at $37,000.
If, however, the price of BTC did not reach the strike price of $35,000, you would only lose your $400 premium.
Keep in mind that if you are using European options, you would have to wait for the expiration date to exercise the option. Since this limits flexibility, the premium charged for European options is usually lower.
A put option is the reverse of a call option. It's a contract that gives you the right to sell a digital asset at a specific price within a given period.
Traders often buy put options if they expect the price to fall. For example, if you had anticipated bitcoin’s drop to the mid $25,000s, you could have bought a put option for 1 BTC at a strike price of $30,000. This move would give you the option to exercise a sell of bitcoin at $30,000 minus the cost of the premium. If you were to use a European option, you would only have this option at the expiration date.
Crypto options trading strategies
The strategy you use for options will determine your success. Here are a few.
Call options: If there are strong bull trends and prices are rising, buying a call option can allow you to profit if the price goes up as expected while limiting your risk to the cost of the contract premium if it doesn't reach the strike price.
Put options: If the market is headed down, people who already hold crypto experience doubt and lack of confidence. But in a bear market, put options can still generate a profit. As the price goes down, buying a put contract ensures you can exercise a sell at your predetermined price.
Selling puts in a market correction: If you have spent any time on crypto Twitter, you have undoubtedly seen #buythedip. It is a classic long trading strategy. If a trader has a long position on an asset, they will use price dips to buy more.
These traders often see bear markets as buy-the-dip opportunities because they offer discounted prices on assets they are long on. However, traders risk #catchingknives by directly buying assets they believe are in correction territory. Catching knives is a phrase for when a trader buys a dip, but the price continues to fall below correction territory into a longer-term or permanent bearish trend.
To hedge the risk of catching knives, traders that believe a digital asset will correct up will sell put option contracts to traders who believe the price will continue to drop.
For example, let's say BTC is at $30,000. You believe that it might dip a little more to $25,000, but it is still a long-term buy. Trader B thinks that the price will drop to $20,000 by the end of the month.
So instead of waiting to buy at $25,000, you sell a put with a strike price of $24,500 (premium of $700). Trader B will want to buy that put option because if they wait to buy BTC at $20,000, it will allow them to sell BTC (or exercise their option) at $24,500
So let's say that BTC hits $25,000 and you decide to cover your position (or buy BTC at $25,000). If the price continues to drop and trader B exercises their right to sell at 24,500, you pocket a $200 profit (minus commission) in premiums. But if the price reverses and the option expires, you benefit from holding a long-term position in BTC plus a $700 profit in premiums.
Managing risk with options
People who want to hold bitcoin and other cryptocurrencies but don't enjoy the market volatility can use options to reduce risk by hedging for potential market moves.
Let's say you're holding BTC, but you think a market correction is coming. Instead of selling your Bitcoin, you could buy put options. If the price goes down, your downside is limited to the premiums you paid.
Another way to manage risk using options is by reducing the capital needed for investment. By spending only the amount of money required to buy an option contract, the remaining capital can gain yields elsewhere for the length of the contract.
Covered vs. uncovered
A covered call is when you sell a call option contract based on assets you hold. If you're long BTC and want to create income, you can sell call options for a strike price lower than where you expect the market to go. You're covered if the contract buyer executes because you own the underlying asset. If the call options expire, you've pocketed the premiums.
Conversely, an uncovered option is selling an option when you don't have a position in the underlying asset. This option selling is risky because you're obligated to the position if the buyer wants to exercise the option.
Option margin is the collateral you must give to a broker before you can write or sell options. This collateral amount varies depending on the broker but must meet minimum federal requirements.
If the value of the margin account drops below the requirement, it can cause a margin call, requiring you to either deposit more or liquidate assets. However, some brokers do not have margin requirements for options like covered calls because the underlying asset is used as collateral.
Unified margin and portfolio margin
A new trading tool called the Unified Margin (UM) system is one of the standout features of the bit.com exchange. It allows traders to manage risk by making all their assets eligible collateral.
You can trade spot, margin, perpetual, futures, and options with a single account. The UM system can improve capital utilization by calculating all your currencies in USD value with specific haircut ratios to provide margin for all your positions.
Trading can be confusing, futures and options trading even more so, but with tools like the UM system, you can run into one less complication while creating your trading strategy.
Since traders often use options trading to protect against significant loss in other trades, options can potentially reduce overall risk in their trading portfolio. Bit.com's 'Portfolio Margin ('PM') tool evaluates the risk of a portfolio by calculating the most likely loss that could occur.' Traders who use this tool can benefit from lower margin requirements if they properly reduce their portfolios’ exposure to loss. This tool, combined with Unified Margin, has the potential to maximize fund efficiency by calculating PnL in real-time.
Crypto options trading can be risky on top of an already volatile crypto market. With margin trading especially, liquidation is a major risk factor. So make sure you educate yourself and trade carefully, knowing what you're liable to lose.
This article is sponsored by Bit.com and originally published on Blockworks.
Bit.com is not offered in the United States of America. Nothing in this article is intended to provide investment, legal or tax advice and nothing in this article should be construed as a recommendation to buy, sell, or hold any investment or to engage in any investment strategy or transaction.
Emily Weber is a content writer and decentralization enthusiast. She aims to read all the way to the end of the internet, so you don't have to. In her free time, you can find her making dank memes and tracking the pseuds on Twitter.