Options trading allows traders to speculate on the future price of an asset without being obligated to purchase the underlying asset, which can help manage or reduce risk.
Options trading used to be the domain of professional traders, but it is now garnering the interest of retail traders.
Bitcoin and ether options are the most heavily traded within the digital asset sector. Cryptocurrency call and put options can be traded on derivatives exchanges like Bybit and Deribit. Crypto derivatives exchanges enable the trading of options contracts for major digital assets such as bitcoin or ether, along with numerous altcoins.
Options trading timeframes
The holder of an option is given the right, but not the obligation, to buy or sell a specific asset, like a stock, or a cryptocurrency, at a predetermined price within a set timeframe.
Options contracts can have various expiry timeframes. Some are short-term, expiring within a week (weekly options), while others have monthly expiry dates on the third Friday of the month.
Certain options, often linked to indices, expire quarterly (March, June, September, and December). Additionally, there are long-term options known as LEAPS, with expiry dates extending over a year or more. The expiration date of an options contract is determined by the specific contract type and the underlying asset being traded.
Call and put options
A buy option is referred to as a "call", and a sell option is known as a "put." Traders holding an option have the right to exercise their option, that is to buy or sell the underlying asset at the predetermined "strike" price. They must do this within the timeframe of the option. Traders can also let their option expire at the end of its predetermined timeframe and only risk losing the premium they paid for it.
Traders generally buy call options when they anticipate that the market price will surpass the strike price at or before the expiry date.
On the other hand, a put option grants the holder the right to sell the underlying asset at the strike price on or before the expiry date, again irrespective of the market conditions. Traders usually opt for put options when they predict that the market price will be lower than the strike price at or before the expiry date.
The risks and rewards of options trading
Options trading offers a unique risk/reward ratio. The maximum loss is limited to the premium paid for the option, while the potential profits can be substantial. Thus, options not only allow traders to speculate on the direction of asset prices but also provide a mechanism to hedge against potential losses.
The only loss a trader incurs by not exercising their option is the premium paid to open it. However, this can still constitute a substantial investment. In the cryptocurrency market, the premiums for options can vary significantly and are influenced by multiple factors.
For instance, consider a trader who invests $500 in purchasing a bitcoin call option with a strike price of $26,000; this option grants them the right to buy bitcoin at $26,000 before or on the option's expiry date. Conversely, another trader might pay a $300 premium for a bitcoin put option with a strike price of $30,000, giving them the ability to sell bitcoin at $30,000 within the option's timeframe. The specific premium amounts are determined by market conditions, the chosen option contract, and the prevailing sentiments and volatility within the cryptocurrency market.
Using options for risk management
A significant advantage of options trading is that it enables traders who hold a substantial amount of a particular asset to acquire options as a safeguard against potential losses in the event of adverse market movements.
For example, a trader expecting a downturn in bitcoin prices could buy a put option, which would offset the losses of their bitcoin holdings if prices did indeed fall. This risk management strategy adds another layer of security to their investment portfolio.
Options can be used to speculate not only on the direction of asset prices but also on their volatility, providing profit opportunities even when the market is relatively stable. However, while options trading offers numerous benefits, it also involves considerable risk and requires a deep understanding of market dynamics.
Disclaimer: This article was produced with the assistance of OpenAI’s ChatGPT 3.5/4 and reviewed and edited by our editorial team.
© 2023 The Block. All Rights Reserved. This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.