Crypto Option Contracts: Introduction to Crypto Options Trading 

Beyond simply buying or selling cryptocurrencies, Cryptocurrency options offer you a versatile toolkit for navigating the volatile crypto market. You can protect your investments, tailor strategies to various market conditions, and potentially generate greater returns with options. By understanding crypto options, you gain the power to adapt, manage risk, and seize opportunities that others miss.  

In this blog, we will unpack crypto options and look at various ways you can use them to get better profits from your Crypto portfolio.

What is A Crypto Option: Crypto Options Contract Explained?

A crypto option is like a bet on whether a cryptocurrency’s price will increase or decrease. It’s a contract that gives you the right, but not the obligation, to buy or sell that crypto at a specific price by a certain date.

This allows you to potentially profit from price changes without owning the cryptocurrency and also offers ways to protect your existing crypto investments without selling your holdings.

Crypto options are one of the most common types of Crypto derivative assets.

A Crypto Derivative is an asset whose value is derived from the price of the underlying cryptocurrency,  similar to how the value of a stock option is derived from the underlying stock price.

Options contracts are not a new invention, with roots dating back to ancient civilizations. However, many people are likely more familiar with the concept from its application in traditional finance.

READ MORE: Crypto Derivatives? Types, Pros, And Cons

Crypto options essentially extend this well-established financial tool into digital assets, demonstrating that the concept is not entirely novel but rather an adaptation of traditional financial instruments.

How Crypto Options Work: A Step-by-Step Guide

Crypto options involve a series of steps to navigate this unique financial instrument:

1. Select the cryptocurrency you want to speculate on (e.g., Bitcoin).
2. Decide whether you think the price will go up (buy a call option) or down (buy a put option).
3. Select the strike price (the price at which you can buy or sell the crypto) and the expiration date (the last day you can exercise the option).
4. Pay a premium to the seller of the option, which grants you the right (but not the obligation) to buy or sell the cryptocurrency at the strike price before the expiration date.
5. If the price moves in your favor, you can exercise the option to buy or sell at the strike price, potentially profiting from the price difference.
6. If the price moves against you or stays the same, you can let the option expire, losing only the premium you paid. Alternatively, you can close your position by selling the option contract before expiration.

Now let’s look at the different kinds of Option Contracts that you can buy in the market.

Call vs. Put: Understanding the Two Types of Crypto Options

Crypto options come in two main types: calls and puts.

We’ll break down what both of these mean with the same example. But before that here are some of the common technical terms associated with an options contract:

Key Technical Terms used in Crypto Options: Key Technical Explained

1. Strike Price: The predetermined price at which the underlying cryptocurrency can be bought or sold if the option is exercised.
2. Expiration Date: The date on which an option contract expires and becomes worthless if not exercised.
3. Premium: This is the buying price of the option contract, i.e price paid by the option buyer to the option seller for the right granted by the option contract. In options trading, the terms “option price” and “premium” are used interchangeably. They both refer to the amount of money that the buyer pays to the seller to acquire the option contract.

1. Crypto Call Option Contract(Right-to-Buy Contract)

A Call Option gives you the right to buy a cryptocurrency at a specific price (the strike price) on or before a certain date (the expiry date). 

Example: You believe Bitcoin’s price will rise significantly. And so on June 1st, 2024, you decide to buy a call option with a strike price of $30,000, expiring on July 1st, 2024. You pay a $500 premium for this option.

This gives you two choices on July 1st (the expiry date): exercise your option to buy Bitcoin at the strike price, or let the option expire.

Scenario 1: Bitcoin Price Rises

If on July 1st (the expiry date), Bitcoin’s price is $35,000, you can exercise your option to buy Bitcoin at the $30,000 strike price. You then immediately sell it at the market price of $35,000, making a profit of $5,000. However, remember to subtract the $500 premium you paid, so your net profit is $4,500.

Scenario 2: Bitcoin Price Falls

If on July 1st, Bitcoin’s price is $28,000, it’s below your strike price. It wouldn’t make sense to exercise your option because you could buy Bitcoin at a cheaper price on the open market. The option expires worthless, and you lose the $500 premium you paid.

2. Crypto Put Option Contract(Right-to-Sell Contract)

A put option, on the other hand, gives you the right to sell a cryptocurrency at the strike price on or before the expiry date.

Example: On June 1st, 2024, you believe Bitcoin’s price will fall significantly. You decide to buy a put option with a strike price of $30,000, expiring on July 1st, 2024. You pay a $500 premium for this option.

This gives you two choices on July 1st (the expiry date): exercise your option to sell Bitcoin at the strike price, or let the option expire.

Scenario 1: Bitcoin Price Falls

If on July 1st (the expiry date), Bitcoin’s price is $25,000, you can exercise your option to sell Bitcoin at the $30,000 strike price. You then immediately buy it at the market price of $25,000, making a profit of $5,000. However, remember to subtract the $500 premium you paid, so your net profit is $4,500.

Scenario 2: Bitcoin Price Rises

If on July 1st, Bitcoin’s price is $32,000, it’s above your strike price. It wouldn’t make sense to exercise your option because you could sell Bitcoin at a higher price on the open market. The option expires worthless, and you lose the $500 premium you paid.

SUMMARY: Think of call options as betting on a price increase and put options as betting on a price decrease.

How are Crypto Options Settled?

Settlement refers to how an option contract is fulfilled when it expires. There are two main types of settlement: physical and cash.

• Physical settlement: In physical settlement, the underlying cryptocurrency is actually delivered to the option holder upon exercise. For example, if you hold a call option on Bitcoin that expires in the money, you would receive the actual Bitcoin specified in the contract.
  
• Cash Settlement: In cash settlement, the difference between the strike price and the spot price of the cryptocurrency at expiration is paid out to the option holder in fiat currency, typically USD (US Dollar). However, some exchanges may offer settlements in stablecoins, such as Tether (USDT), depending on the specific contract.

Cash settlement is generally more common in crypto options trading.
This is because it’s easier to manage and doesn’t involve the complexities of transferring and storing cryptocurrency. However, some platforms do offer physical settlement for specific options contracts.

Advantages of Crypto Options

Crypto options offer distinct advantages for traders:

• Hedging: Options act as insurance, protecting existing holdings from price drops (using put options) or locking in future buying prices (using call options). This minimizes potential losses in volatile crypto markets.
• Speculation: Traders can profit from correctly predicting price movements without owning the underlying asset. This opens opportunities for higher gains with limited capital investment.
• Flexibility: Options come in various types (call/put) and strike prices, allowing traders to tailor strategies to specific market views and risk tolerances.
• Leverage: Options provide the ability to control a larger position in the underlying asset with a smaller capital outlay. This amplifies potential profits, but also losses, requiring careful risk management.
• Diversification: Options can complement existing crypto holdings, diversifying a portfolio and reducing overall risk exposure.
• Limited Risk: For option buyers, the maximum loss is limited to the premium paid for the option, unlike directly owning the asset, where losses can be substantial.

Risks Associated with Crypto Options

Crypto options trading presents unique risks:

• High Volatility: The extreme price swings common in cryptocurrencies can lead to significant losses, especially for inexperienced traders.
• Lack of Regulation: The crypto options market is less regulated than traditional options markets, exposing traders to potential scams and market manipulation.
• Limited Liquidity: Some crypto options may lack sufficient trading volume, making it difficult to enter or exit positions at desired prices.
• Complexity: Options strategies can be complex, requiring a deep understanding of their mechanics and potential outcomes.
• Counterparty Risk: The risk that the exchange or counterparty in a trade might default or fail to fulfill their obligations can be higher in the crypto space.

Traders should thoroughly research and understand these risks before engaging in crypto options trading. Implementing risk management strategies, such as using stop-loss orders and diversifying portfolios, is crucial for mitigating potential losses.

European vs. American Options

European Crypto options is a slightly different version of Crypto options that is available in some Crypto exchanges. The only difference is that European crypto options can only be exercised on the expiry date, making them less flexible and hence more cheaper than the Normal Crypto Option(ie American Style Crypto options) 

In-the-Money (ITM), At-the-Money (ATM), Out-of-the-Money (OTM)

In options trading, ITM, ATM, and OTM are terms used to describe the relationship between the strike price of an option and the current market price of the underlying asset (in this case, cryptocurrency). This relationship, known as “moneyness,” is crucial in determining the option’s intrinsic value and potential profitability.

In-the-Money (ITM)

• Call Option: A call option is ITM when the strike price is lower than the current market price of the cryptocurrency.
• Put Option: A put option is ITM when the strike price is higher than the current market price of the cryptocurrency.
• Intrinsic Value: ITM options have intrinsic value, meaning they would result in a profit if exercised immediately.

At-the-Money (ATM)

• An option is ATM when the strike price is roughly equal to the current market price of the cryptocurrency.
• Intrinsic Value: ATM options have little or no intrinsic value. Their value is primarily derived from their time value (the potential for the underlying asset’s price to move in a favorable direction before expiration).

Out-of-the-Money (OTM)

• Call Option: A call option is OTM when the strike price is higher than the current market price of the cryptocurrency.
• Put Option: A put option is OTM when the strike price is lower than the current market price of the cryptocurrency.
• Intrinsic Value: OTM options have no intrinsic value. Their value is based solely on their time value.

Example with Bitcoin Options:

Let’s assume the current market price of Bitcoin is $32,000.

• Call Option: A call option with a strike price of $30,000 would be ITM.
• Put Option: A put option with a strike price of $30,000 would be OTM.
• Both Call and Put Options: Options with a strike price of $32,000 would be ATM.

Why Moneyness Matters:

• Pricing: ITM options are more expensive than ATM or OTM options due to their intrinsic value.
• Profit Potential: ITM options have the highest profit potential if exercised, but they also carry the highest cost.
• Trading Strategies: Different option strategies utilize ITM, ATM, and OTM options to achieve specific goals, such as generating income, protecting against losses, or speculating on price movements.

Crypto Option Greeks

Option Greeks are a set of risk measures used to evaluate the sensitivity of an option’s price to various factors. Think of them as the vital signs of an option, offering insights into its potential behavior and helping traders make informed decisions. Here are the main Option Greeks:

• Delta (Δ): Measures how much an option’s price will change for every $1 change in the underlying asset’s price. A delta of 0.5 means the option price will move $0.50 for every $1 change in the underlying asset.
  
• Gamma (Γ): Indicates how much delta will change when the underlying asset price changes. A high gamma means the option’s delta is very sensitive to price changes, potentially leading to larger gains or losses.
  
• Theta (Θ): Measures the time decay of an option, or how much its value decreases as it gets closer to expiration. A high theta means the option will lose value quickly as time passes.
  
• Vega (ν): Indicates how much an option’s price will change for every 1% change in implied volatility. A high vega means the option is more sensitive to changes in volatility, which can be both beneficial and risky.

Understanding the Greeks is crucial for effective crypto options trading. Here’s how traders use them:

• Risk Management: Greeks help traders assess and manage the risks associated with their options positions. For example, a high delta option may be more profitable but also riskier, while a low delta option may be safer but less profitable.
• Strategy Development: Traders can use Greeks to develop and fine-tune their trading strategies. For example, they might use gamma to identify options that are likely to experience rapid price changes or theta to choose options with favorable time decay characteristics.
• Position Adjustments: Greeks can help traders determine when to adjust their positions based on changing market conditions. For example, if vega is high and volatility is expected to increase, a trader might choose to buy more options to take advantage of the potential price movement.

6 Options Trading Strategies Explained

Here are some of the strategies that become possible with Crypto options.

1. Covered Call: Own an asset and sell a call option on it. Generate income on the asset while limiting potential upside if the price goes up.
2. Protective Put (Married Put): Own an asset and buy a put option on it. Protect against price drops by locking in a selling price.
3. Bull Call Spread: Buy a call with a lower strike, sell a call with a higher strike. Profit if the price rises moderately, but limit both potential gain and loss.
4. Bear Put Spread: Buy a put with a higher strike, sell a put with a lower strike. Profit if the price falls moderately, with limited risk and reward.
5. Long Straddle: Buy a call and a put with the same strike price. Profit from a large price swing in either direction, but risk the total premium paid.
6. Protective Collar: Own the asset, buy a protective put, sell a covered call. Limit downside risk and upside potential while generating income from the call premium.

These are just a few examples of options trading strategies. Each strategy has its own unique risk-reward profile and is best suited for different market conditions and trader preferences. Remember, options trading can be complex and involves risks, so always do your research and consider consulting a financial advisor before making any trades.

Future Prospects of Crypto Options Market

Crypto options trading has gained significant popularity, driven by increasing institutional adoption and growing interest from retail traders. The market is still nascent compared to traditional options, but its growth has been exponential.

Institutional investors, including hedge funds and asset managers, currently dominate the crypto options market. Their involvement has brought liquidity and helped establish the market’s legitimacy.

Although institutional investors hold the majority share, retail traders are increasingly participating in crypto options trading. The accessibility of crypto options through various exchanges and platforms has made it easier for retail investors to enter the market.

The crypto options market has experienced remarkable growth in recent years. The trading volume and open interest have surged, indicating strong market activity and increasing adoption. Future projections suggest continued growth, driven by factors such as increasing institutional involvement, regulatory clarity, and the expansion of crypto derivatives products.

Conclusion

Crypto options are powerful tools for traders of all levels, offering diverse ways to navigate the cryptocurrency market. From hedging and speculation to advanced strategies, options provide flexibility and potential for significant gains. 

While risks exist, understanding the fundamentals and employing prudent risk management can help traders harness the benefits of crypto options. As the market matures and evolves, crypto options are set to play an increasingly pivotal role in the future of cryptocurrency trading. However, it is crucial to remember that a thorough research-first approach is essential to understanding the complexities of crypto options and making informed trading decisions to mitigate risks and maximize potential profits. This is where Mudrex can help you. The Mudrex app offers an easy to use interface with ample, well researched learning resources that you can use to jumpstart your Crypto investment Journey.

Download Mudrex App Now and Get Started with Crypto Trading.

FAQs

1. What is cryptocurrency options trading?

Imagine cryptocurrency options trading as purchasing a ‘ticket’ that predicts the future price of a cryptocurrency. This ‘ticket’ grants you the right (but not the obligation) to buy or sell a specific amount of crypto at a certain price by a certain date. However, this ‘ticket’ isn’t free-it comes at a cost known as a premium. Options trading can be a strategic move to protect your investments or a calculated risk to speculate on the future price of a crypto.

2. How do you explain crypto trading?

Crypto trading involves buying and selling cryptocurrencies, such as Bitcoin or Ethereum, to make a profit. You can trade on special platforms called exchanges, where you can swap one crypto for another or traditional currencies like dollars. It’s like trading stocks but with cryptocurrencies instead.

3. How do you explain options trading?

Options trading allows you to buy or sell an asset (like a stock or a cryptocurrency) at a certain price by a certain date. It’s like having a reservation at a restaurant – you can choose whether or not to use it. This can be useful for protecting your investments or making extra money based on how you think the price will move.

4. Is trading crypto options legal in India?

While there’s no outright ban, the regulatory landscape is still evolving. Trading crypto options comes with risks and requires a good understanding of the market. Always do your research and consider seeking advice from a financial professional.