What Are Bitcoin Options?
The world of investing is characterized predominantly by the maximization of profits. Every year, numerous innovations spring up to help investors profit in whatever capacity and whichever field an opportunity presents itself.
One tool used to increase profitability in global markets is financial instruments. Though virtual and conceptual, these instruments expand an investor's portfolio and create new ways to profit from a single asset or asset class. One such financial instrument is called options.
Though popularized only in recent times, the concept of options trading dates back to the 17th century. This concept is founded on a financial theory that gives certain permissions and withholds certain rights. Essentially, options are contracts that give an investor or trader holding an option the right (not the obligation) to buy or sell an asset at a predetermined price and date.
Options belong to a class called derivatives, and a key attribute of assets that fall into this class is dependency. This means that the value of options is derived from that of other instruments such as cash, bonds and other derivatives.
Options track underlying assets and then reflect the value to be traded. Across industries, they have proven to be highly useful in generating income, hedging against price movements and profiting from speculative trading.
While the concept can be technical and rather confusing, one thing is for sure: Options are a profitable tool that can definitely become an investor's best friend. In this article, let’s discuss everything you need to know about a particular type of crypto option: Bitcoin options.
The Rise of Bitcoin: A Short History
Over the past few years,Bitcoin has grown to become a household name evoking a wide range of emotions: Curiosity, hope, fear, skepticism ... and much more.
Its growth over 12 years took the world by surprise. First appearing in a white paper in October of 2008, pseudonymous author(s) Satoshi Nakamoto introduced a concept that would later give centralized financial institutions worldwide a run for their money.
Birthed out of a desire to correct the flaws and misappropriations of the existing financial systems, Bitcoin came as a solution to "rip-off" middlemen and unfair financial regulations. From a value of $1 in 2011 to reaching an all-time high of $68,000 in Nov. 2021, Bitcoin has experienced crazy growth. Its price currently stands at approximately $40,000 per coin.
Since 2011, Bitcoin has grown from its first use case (as a medium of exchange for pizzas) to being adopted by millions of users and corporations worldwide,using it in their day-to-day transactions. In Sept. 2021, it officially became a legal tender in El Salvador, with more countries looking to follow suit.
While Bitcoin has yet to fully mature, it’s come a long way and kick-started a new chain of events in the world's financial systems.
Are There Options on Bitcoin?
Yes, there are. Bitcoin options exist: Similar to Bitcoin futures, they’re a form of derivatives. They can be defined as "contracts that give an investor or trader the right to buy or sell Bitcoin (but not the obligation) at a given price (strike price) and a specific date (expiration date)."
Bitcoin options trading is preferable to buying Bitcoin, because the cost incurred to buy an option (a premium) is less than that of the actual asset. As opposed to buying and holding Bitcoin, Bitcoin options give you the leverage to take speculative positions (i.e., upward or downward) on BTC's price movement.
Considering how volatile the cryptocurrency asset is, Bitcoin options are a beautiful concept. They allow you to profit from the downward movement in price without actually suffering the loss of holding the currency itself. Bitcoin options also allow you to profit from a spike in price as if you were holding the actual coin.
In addition, Bitcoin options are an excellent choice for investors and traders who understand how it works. Apart from the high volatility in Bitcoin that creates wide profit margins, losses are limited only to the premium paid to open the positions. This uncapped profit potential and capped losses are some of the best features of Bitcoin options trading that makes it attractive and in demand.
Bitcoin Call Options
A Bitcoin call option is an agreement that allows a call option owner to buy an agreed-upon amount of Bitcoin for a particular price (also known as the "strike price") at a particular time (expiration date).
Consider the following (hypothetical) scenario: Let's say you believe that the price of a piece of land will go up in a couple of months. You discover that you can reach an agreement with the seller that would allow you to purchase the land at a particular price, and mandate the seller to sell it to you ... all this at the small cost of a fee (premium). Would you accept the offer? Probably. This same logic applies to Bitcoin call options.
To clarify, the agreement merely gives you the "option" to buy the land at that time and isn't mandatory. If you don't have the funds at that time to close the deal, all you have to do is forfeit it and lose the fee paid.
Bitcoin Put Options
This instrument allows the contract owner to sell Bitcoin at an agreed-upon price later. Simply said, a Bitcoin put option gives you the privilege of selling your "stock." It usually follows a downward bias — that is, when an investor feels the price of Bitcoin will decline rapidly, or is bound to do so over a certain time frame.
Why Would Anyone Buy a Bitcoin Put Option?
To help you understand better, here's an example: Mr. Stone is a fruit seller who notices that fewer people buy more fruit at a particular time of the year, which forces the price of fruits down. Throughout this period, he consistently runs his business at a loss, because he has to sell his produce at a lower price than what he bought it for.
One day, he hears of a company that wants to buy his fruits at a predetermined price, even when that price is lower than the market rate. This opportunity allows him to sell his goods to them at that price and hedge against decline, even when other fruit sellers have no choice but to make do with less-than-ideal selling rates.
Mr. Stone and the company enter an agreement that mandates the company to buy his goods at the predetermined price within that period. This contract is sealed with a fee (premium). If the company refuses to act on the contract, Mr. Stone gets to keep the premium that was paid.
It's worth noting that Mr. Stone gets to decide the premium paid based on the perceived demand for his fruit at that time. The same logic applies to Bitcoin put options.
Holding And Writing Bitcoin Options
"Holding and writing" in options trading is another way to express the act of buying and selling. Like buying and selling, there are two sides to an options contract; On one side is the "holder," or buyer, and on the other is the "writer," or seller. This two-sided concept covers both put and call options — meaning that you can go long or short on both.
The connection between a holder and a writer is the premium paid. When an investor decides to "hold" an option, then they’re obligated to pay a premium that gives them the right to buy or sell Bitcoin.
The reverse is true of "writing." When an investor decides to “write,” they sell their right to decide to the holder. If the holder decides to act on the options contract, the seller will have to keep their word and relinquish their right. They only get paid the premium for the decision.
Source: Robinhood Learn
Certain terminologies are used to understand the factors responsible for an option's price in Bitcoin options trading. These terms are called the "Greeks." They decide how much you pay to open an options contract as a holder, or how much you receive selling an option as a writer. Although you’ll see terms like Delta and Theta, please don't be intimidated — we're not going back to Math/AP class. Here are the five members of the Greeks:
Delta reads how reactive an option's price is to a point move in Bitcoin's underlying price.
Gamma denotes how much the Bitcoin option's delta moves, for every point move in the underlying Bitcoin price.
Theta measures the rate of decay of a Bitcoin option with time. The lower the theta, the farther from the expiration date; the higher the theta, the closer to the expiration date.
Vega keeps a tab on how sensitive an option is to the implied volatility in the underlying Bitcoin price. It measures the rate of change of an option's premium, with a 1% change in volatility. Bitcoin is a volatile asset, so vega holds a bigger vote in determining option price.
Rho shows the reaction of an option's price to changes in interest rates.
Bitcoin vs. Bitcoin Options
The relationship between Bitcoin and Bitcoin options can be likened to that between a mother and her child. While both have the same DNA, and share a number of physical/biological similarities, they are not of the same body — with the child being an extension of their mother. In the same way, Bitcoin options can be perceived as an extension of Bitcoin.
We already know why BTC is sold and is currently the biggest cryptocurrency by market cap: High demand. However, Bitcoin options (and other derivatives) are sold because they serve certain specific purposes, which we shall explore in detail below.
Hedging is one of the most common reasons for trading futures or contract options.
To understand hedging, picture a garden close to a river or water pathway. It's safe to presume that such a piece of land will, sooner or later, get washed away by the force of water currents. In such a situation, the owner of the land builds a fence or hedge around it to shield it from erosion.
This example is a close, albeit simplistic, representation of hedging in the financial markets. Investors (and miners of Bitcoin) hold an asset whose value could be “eroded” or "washed off" by the forces of supply and demand. An options contract "shields" the value of the underlying asset — in this case, Bitcoin — by "locking" its value, i.e., the price at which Bitcoin can be traded for money.
Traders and investors use contracts such as options to express their short-term sentiments (bullish or bearish) on an asset.
To understand this better, remember that when an asset is bought, it’s usually believed that the asset will be more valuable in the future. When the asset records a substantial increase in value, you can profit by selling off an amount of it.
What happens, however, when you feel a bearish run is imminent in the upcoming months? Although the underlying asset's price may bounce back after a while, by purchasing a put option you would maximize your chance to make some profit.
The Benefit Of Leverage
Here’s another reason Bitcoin options are increasingly traded over Bitcoin itself: Trading an options contract provides you with the benefit of trading more funds than you have. These funds are usually provided by the exchange on which the instruments are traded. A larger amount of fund (capital) means more potential profit, but also entails a higher level of risk. In Bybit, you can leverage up to 100x on your capital.
Expiration dates refer to the agreed date on which the contract option — the option of either buying or selling — is to be exercised. Note that not every Bitcoin options contract can only be fulfilled on its expiration date; some can, in fact, be exercised before the expiration date. Below, let's look at the two methods of contract fulfillment.
European-Style Options Contracts
European-style options contracts mandate the holder to fulfill only the terms of the agreement on the date of expiration. Even if a contract is in the money (ITM), the holder can't exercise their option until the set date, on which the fortunes of such a contract may have reversed.
A European-style contract requires higher accuracy in speculation than its American counterpart. At the time of this writing, major Bitcoin options trading platforms offer only European-style contracts.
American-Style Options Contracts
Options contracts styled in this manner give the holder the privilege of exercising the contract before the expiration date. If a contract is ITM, the holder can decide to use their trade option, thereby making a profit.
The American way of doing things implies that a much lower degree of accuracy in speculation is required. Making a profit requires the contract to be ITM any time: Between the date entered and the expiration date.
Buying Bitcoin Options
Bitcoin options are offered on several exchanges, which have different methods of allocating contracts. For example, on a crypto exchange, the options contract is upheld directly between the customer and the exchange.
To enter a contract option, the user chooses the amount of Bitcoin they wish to trade the options contract on, thus determining the premium. Since the trade takes place between the user and the exchange (using a computer program), if the value being lost by the user were to pass a threshold, the user would be liquidated to restrict losses, with the only money lost being the premium.
On some other exchanges, a user "writes" a contract and waits for their contract to be matched by another who orders to purchase a contract with similar terms to the writer. The exchange regulates this trade, and a fee is charged to ensure fairness.
Are Bitcoin Options A Good Investment?
To the Bitcoin miner, options are sure to keep their rewards at reasonable levels. To the Bitcoin investor, Bitcoin options are a good way to make profits from the rise and fall of Bitcoin. It ensures that you keep smiling all the way to the bank (as long as your speculations are spot-on), no matter the situation in the main market. Even if BTCis bleeding red, you can make money like a true businessperson.
To the investor who wants a "feel" of the market without prior experience with Bitcoin or cryptocurrencies, no worries: There's an option (pun intended) for you in the form of Bitcoin options contracts. (Editor’s note: Please ensure that you’re educated on the risks involved. Only go for options trading if you’re comfortable stomaching the level of risk).
The goal of every trader and businessperson is to make a profit; no one sets out to lose. Due to the sophisticated nature of economic systems, this goal is now more achievable than ever. Newly introduced layers of trade (AKA derivatives) have found their way into the crypto financial system, and helped drive the growth of cryptocurrencies significantly.
On the flip side, more ways to make money means more ways to lose money. Crypto options require caution and not (ideally) a mindset of "get rich quick." In order to maximize your gains, you'll need plenty of patience, as well as the ability to spot opportunities and act on them quickly.
We hope this guide has helped you grasp the fundamentals of BTC options. As long as you do your research and understand the risks, you’ll be set to purchase your first Bitcoin option.