Options Contracts in the Crypto market: Beginners Guide
Crypto assets exist only for a decade, and yet we are seeing complex financial products being introduced in the market. After futures contracts, we are now seeing demand for options contracts as well. But the problem here is that the majority of crypto investors (and not only) don't understand these products and don't have the knowledge to trade them. After Binance launched XRP options contracts, many people asked me how they worked. This blog is dedicated to the people who want to understand how options work and how they can use them for hedging or leveraging. Options are a great tool to either reduce risk or leverage and profit, no matter if we are in a bull or bear run.
Let's start with what an options contract is. An options contract is a type of derivative, a derivative contract which is simply an agreement between two parties to facilitate a potential transaction on the underlying asset (stocks, bonds, crypto assets) at a specific price that is set from the start, referred to as the strike price, prior to the expiration date.
An options contract gives the buyer or the holder the right but not the obligation to either buy or sell the underlying asset at the strike price within a given period of time. There are two types of options, call options and put options. In few words, the right to buy is the call option, and the right to sell is the put option.
Call Options: If you are bullish on a crypto asset, for example, expecting prices to increase, then you should buy a call option. In this arrangement, you exercise your option by buying at the strike price if prices are higher. Generally, traders buy a call option if they are confident about the crypto asset's future, and they believe that the price will increase before the expiration date. In a call option transaction, a position is opened when a contract or contracts are purchased from the seller, also referred to as a writer. In the transaction, the seller is paid a premium to assume the obligation of selling shares at the strike price.
Some people will ask why not simply buy the asset directly instead of buying an option? While investors or traders could simply buy the asset, they would have direct exposure to the asset’s price risk up to its entire principal and this is especially risky with a volatile asset class like crypto assets. When buying a call, however, the risk is capped at the premium paid to purchase the option.
Example: You expect XRP price to increase during the next month, so you buy an XRP call option with a strike price of $0.20. Usually, a contract covers 100 pieces of the asset, but it can be adjusted with more or less. Let's take in this example that you buy one XRP call option which covers 100 XRP with a strike price of $0.20 and expires in one month. To buy that contract you have to pay a premium which is determined by several factors (moneyness, volatility, expiration date etc.) and this goes to the seller's pocket. Let's say that the premium is $1 per contract. If within a month the price of XRP increases to let's say $0.25 then you have two options:
- You exercise the contract and you buy 100 XRP (or how much the contract says) for $0.20 (strike price), which equals to $20 and if we include the $1 premium that you spent to buy the contract, then you have paid $21 and you can now either hold or sell the XRP for $25 (because the current market price is $0.25). Like that you have a net profit of $4. So, in order to calculate the profit or loss you will have if you the contract, you will have to include both the cost to buy the asset at the strike price and the premium. If the market price is less than the strike price then you do not do anything and you simply lose the $1 (premium you paid) and let the contract expire.
- You sell the contract in the market (usually if you are not interested in buying the asset) and profit from that. For example, you bought the contract for $1 so now the price (premium) will be higher and around $5, so more or less you will make the same profit.
Put Options: : If you are bearish on a crypto asset, for example, expecting prices to fall in the future, then you can bet on the future price decrease by buying a put option. In this arrangement, you exercise the put option if prices are lower than the strike price.
Example: You expect XRP price to decrease during the next month, so you buy an XRP put option with a strike price of $0.20. Same as previously, the contract has 100 XRP and it costs $1 to purchase it. If within a month the price of XRP decreases to let's say $0.15 then you can either sell the contract to the open market and profit or exercise it by either buying 100 XRP to the open market in the price of $0.15 and selling them to the seller of the option at the price of $0.20 (strike price) or, if you are already an XRP holder, sell your XRP that you already hold at $0.20 and then buy with that profit more XRP at the price of the market ($0.15).
All in all, an options contract offers its holder versatility and is often used to hedge or speculate on underlying asset prices.
A good strategy to hedge a long-term investment is a simple protective Put. A protective put seeks to limit downside while preserving the upside. In this case, investors buy a put option on a long-term investment to hedge against potential losses, with a limit on upside equal only to the put’s premium. If investors have been increasing exposure during this recent bear run with predictions of a rally, they may want to purchase a protective put, limiting their downside.
2 important notes here:
The contract can be settled directly in cash instead of having to buy the underlying the asset and sell it and do all this procedure.
Not all options are the same. There are American and European options. You can exercise American options at any point in their lifetime, from the moment you buy till the expiration date. On the other hand, European options can only be exercised in the expiration date and not before, but they can be traded at any time.
Some people may also ask what are the differences between a futures and and an options contract:
Finally, there are also 2 other ways to go long or short in an asset, but it is not recommended for beginners, and they have much more risk than simply buying a call or put option:
Investors who believe an asset price will increase in the future, can write/sell a put option. When selling a put option, traders agree to buy the underlying asset at the strike price if the buyers choose to exercise their right to sell. If the spot price of the asset is greater than the strike price, buyers will choose not to sell, and the option writer will profit from the premium.
Investors who believe that an asset price will decrease in the future, can write/sell a call option. When writing a call option, traders agree to sell the underlying asset at the strike price if buyers exercise their right to buy. Similar to above, this strategy aims to collect the premium on the option, while buyers choose not to exercise their option. This occurs when the spot price is lower than the strike price. If the spot price is higher than the strike price, the writer of the call will have to sell the asset at a discount.
Binance, the biggest and most popular crypto exchange, recently launched options trading and it is clarified that Binance is the sole-issuer of the options contracts. Thus, users can only be a buyer of Binance Options. As option holders, users of Binance Options are not exposed to unlimited downside, unlike traditional option sellers. In this case, the maximum loss would be the premium paid for the options. If you want to specifically trade Binance option then click here.
Options trading requires skills and an understanding of the variables that affect option prices. Investors should be very careful and keep an eye on the price of the option, the strike price, and the maturity. This way, you ensure that you buy the right options.