Options Pricing: How It Works & Why It Matters

At first glance, crypto options may appear to be a foreign concept … especially to the uninitiated. Though more technical than day-to-day trading, there’s no need to be intimidated — when broken down into bite-sized pieces of information, crypto options are, in fact, not as complex as you may think. For starters, let’s take a look at how crypto options are priced.

At its core, the price of a crypto option is determined by two key parameters: Intrinsic value and extrinsic value. In this article, we look at crypto option pricing, delving into the aspects which make a crypto option valuable. If, while reading this article, you feel confused at any point, just sit tight and read on till the end … we promise it will all eventually make sense.

What Are Crypto Options?

An option can be defined as “an agreement that confers the buyer the liberty (not the obligation) to exchange or buy a current or existing investment at a foreordained price before a particular date.” A crypto option follows the same underlying logic as a stock option, but has more potential for leverage.

Options have somewhat diminished the dangers and expenses associated with buying stocks. They’re a useful technique for trading digital assets. Options provide investors an amazing chance to anticipate or guess the future value of an underlying asset, which can then be purchased in fiat or digital currencies. 

Source: Ledger Insights

Crypto options are arguably more desirable than their stock counterparts, since cryptocurrencies such as Bitcoin can go for thousands of dollars per coin/token. With crypto options, you can invest in a certain cryptocurrency without owning the actual asset, and stand to profit exponentially at a lower risk level.

Intrinsic Value of a Call Option

This may be the least difficult concept to grasp. An option is declared to possess intrinsic value if it’s worth something at the time of expiration. 

For example, let’s presume the market cost of an asset to be $70 and the investor possesses a call option worth $60 each. This call option has intrinsic value and is declared as in the money (ITM) because, at expiration, the investor can acquire a hundred shares at $60 instead of the current market cost of $70. 

Therefore, the intrinsic value is defined as the difference in value between the call option and the underlying stock price. In this situation, $70 − $60 = $10.

Alternatively, a call option is declared as out of the money (OTM) if, at termination, it has no intrinsic value. Following a similar illustration, presuming the stock price tumbles to $50, it would retain no intrinsic value because no investor will call at $60 when the current market cost is $50. This renders the shares worthless.

Intrinsic Value of a Put Option

A put option is declared to possess intrinsic value if its price is higher than the current stock price. 

For example, presuming that an investor buys a put option of $75 when the market price is $70, the investor retains liberty to trade at $75 regardless of the current market price. The intrinsic value estimation, as those mentioned above, is calculated as the difference in value between the prices of the option and stocks. For this situation, $75 − $70 = $5. This infers that each share retains an intrinsic value of $5.

Again, presuming the stock price ascends to $80, and the put option is worth $75, the put is viewed as OTM because the vendor can just trade at the $75 put value, instead of the $80 stock market price, which renders the put option valueless.

Extrinsic Value

EV incorporates a blend of different variables , including implied volatility and time decay, which we'll consider later in this article.

What Types of Crypto Options Are There?

Essentially, two types of options exist: Call options and put options. A call option allows an investor to acquire an underlying asset, while a put option allows an investor to sell an underlying asset.

Crypto Call Option

When buying this option, an investor (the buyer) earns the freedom to acquire contracts from the vendor of the specified asset at a fixed value commonly described as the “strike price.” This exchange window is open for only a limited duration, as the buyer must utilize their “call” before the particular date of expiration. 

The crypto call option is generally held in expectation of a rise in the market price of the stock. This is because in a scenario where market price outperforms strike price, the investor buys the stock from the seller at the strike price, which is lower than the current market price, thus inducing a profit.

Otherwise, the stock price dwindles, and the investor lets the call option expire, with the only loss being the premium fee (a specific amount paid to purchase the option).

Crypto Put Option

A crypto put option gives the buyer the freedom to compel the vendor of the “put” to pay for a hundred shares of a specific stock at the strike price from them. The put option is held with a bias to see a drop in the market price of a specific stock, far below the strike price. When this occurs, the vendor who traded the put is compelled to pay for the shares at the strike price, which is above the present market price, resulting in a profit for the buyer. 

However, if the market price spikes instead of diminishing, the smartest move is to let the option reach expiration, and forfeit just the premium fee. The put option works as a protection system, a type of insurance that secures the buyer from an excessive stock value decline.

Factors to Consider

A few factors influencing the value of options (which can be referred to as extrinsic value) — are unavoidable. These are as follows:

1. Underlying Stock Price

Fluctuations in the underlying stock price directly influence the worth of both call and put options. A spike in the price of a certain stock will naturally prompt a boost in the price of call options, on the grounds that the stock can be acquired at a cost less expensive than the prevailing market price. Likewise, a decline in stock price will bring about an increment in the price of put options on the grounds that the stocks are being sold at a more exorbitant price than the plunging stock price.

2. Volatility

The idea of volatility is quite complex. It’s upheld by a component referred to as statistical or historical volatility. This factor takes into account the market value of a stock over a specified time frame. 

Within the legitimacy time frame of an option, a trader is regularly expected to input future volatility. Of course, no trader knows what will occur in the financial exchange market. The trader can make a calculated assumption by analyzing past variables, such as profits, interest rates and time span.

These factors give rise to what is known as implied volatility, which is a vital indicator utilized by options traders to estimate the possible period of occurrence of future volatility.

Implied volatility is utilized to determine the price of options, regardless of whether they’re cheap or costly. The higher the implied volatility, the higher the premium levels, and vice versa. Once investors fully grasp this concept, they can observe when to buy (when the premium fee is low) or when not to buy (when the premium price is expensive).

3. Date to Expiration (DTE)

Time is a simple concept in the real world. However, it takes a great deal of experience and research to completely comprehend its impact on a stock, due to a concept known as time to expiration. Time naturally leans toward the stock trader, meaning that the stock prices of good organizations tend to increase over a period of time. 

Then again, time can be the adversary of the options trader. Assuming there is no perceptible change in the price of a stock over a period of days, it automatically leads to a decline in the value of the option. Furthermore, as an option approaches expiration, its value generally diminishes. 

Assumptions to Make

There are different models used to determine the price of an option — and each model comes with different assumptions. Many of these models consider a few variables, such as strike price, volatility, current market price, interest rates and time to expiration, in order to give a close estimate of (or accurate conclusion on) the price of an option. 

Of the many models used to price options, a few notable ones are the Black-Scholes model, Monte Carlo simulation, and Binomial options pricing. All of these models share a similar goal: To calculate the chances of an option being ITM at the point of expiration so that a monetary value can be given to it.

Black-Scholes Model

Here, we’ll consider one of the most renowned models, the Black-Scholes model, to understand how it works. Fischer Black and Myron Scholes came together and created a formula for obtaining a theoretical price for derivatives with time to expiration. They published a pricing model in 1973 that’s now referred to as the beginning of an evolution for the contemporary options market.

The Black-Scholes model formula is as follows: 

Source: Investopedia

As seen from the image above, the Black-Scholes model comprises 7 variables in total:

• Call option price

• CDF of the normal distribution

• Spot price of an asset

• Strike price

• Risk-free interest rate

• Time to maturity

• Volatility of the asset

Here are some of the assumptions made for these variables: 

• Stock prices are log-normal in nature (that is, lognormally distributed) because the price of an asset cannot read negative.

• There are no taxes or transactional fees.

• The risk-free rate is the same for all maturities (that is, the date on which the options end).

• Short-selling using proceeds is permitted.

• There is no arbitrage without considering risks.

• Options being valued are all European-style. 

While the Black-Scholes model is highly respected, all its assumptions don't hold true now. This has introduced modifications to the model to suit market conditions better. There are also other models to consider in pricing options.

Cryptocurrency Options vs. Stock Options

Volatility Level

While the stock market can be unstable, the cryptocurrency market is incredibly volatile. For instance, in 2021, Bitcoin lost the greater part of its worth in a couple of months, but later appreciated by 100%, essentially doubling in value. [Editor’s Note: Readers of this article need only look to the week of May 10, 2022 for volatility in the crypto market.]

Such unpredictability makes cryptocurrency trading a challenge for unprepared financial investors. Unlike stock options, where 1 contract is equivalent to 100 shares, in cryptocurrency, 1 contract is equivalent to 1 share (e.g., 1 BTC.)

Backing/Dependency

Stocks are a proprietorship interest in an organization, so a stock's performance relies on the organization's prosperity over the long haul. Since cryptocurrency is, for the most part, not backed by resources or income, it depends heavily on favorable public and corporate sentiments to raise its price.

Stock and cryptocurrency markets have been found to be largely correlated, and this correlation looks to increase with the passage of time. When the stock market is in the red, major investors (e.g., financial institutions, crypto whales) may choose to liquidate crypto assets in favor of stocks, causing the prices of the former to plunge.

Trading Hours

Cryptocurrency options are run on a round-the-clock basis, while stock options typically run on weekdays during regular market hours (9am–5pm).

Buying Crypto Options

Getting started with crypto options is as simple as these three steps:

1. Decide what crypto option platform you plan to use.  As an example, BTC options are available for trading on Bybit.
2. Deposit your investment into the platform.
3. Make your crypto options trades.

There are many different platforms available with different offerings, and they vary in security, reliability, ease of access and ease of use. There’s no one-size-fits-all: We recommend you DYOR to find the best fit.

Are Crypto Options a Good Investment?

The fundamental benefit of buying crypto call options is that a call trader doesn’t have to commit to exercising the contract if the seller in question would rather not. The risk for buying call options is restricted to the fee paid for the premium. This means that on the off chance that the market moves against call traders, they don’t need to stress over incurring losses aside from the premium fee. With high potential gains and restricted loss, crypto options serve as a good investment.

[Editor’s note: A word of caution — don't jump into crypto options purely because of hype, and never invest more than you can stand to reasonably lose.]

Conclusion

Crypto options are becoming very popular. From a trader’s point of view, the level of leverage crypto options come with, as well as the mitigation of losses they provide, make them a great investment opportunity.

As we’ve said before, it might seem all technical and complex at the beginning, but spending the time to understand crypto options and reading up on related resources online with focus will help you become an expert.

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