How do bitcoin options work?

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The cryptocurrency market is constantly evolving, integrating with traditional and inheriting complex financial products such as futur...

The cryptocurrency market is constantly evolving, integrating with traditional and inheriting complex financial products such as futures and options.
Several types of futures contracts are already well established in the bitcoin industry. This is noticeable in the activity of traders on the CME.
However, with options, the situation is somewhat different. These derivatives are difficult to understand among ordinary market participants and are not yet so popular.
Nevertheless, there is a demand for such tools, as evidenced by the growth dynamics of this market segment and interest from platforms such as Binance and Bitfinex.
Bitcoin options are already listed on regulated and primarily whale-focused exchanges CME, LedgerX and Bakkt. Deribit leads the unregulated market, followed by FTX and OKEx.
In the article, we understand what options are and what types of options are, as well as consider the features of these instruments and the current state of affairs in the segment. 

What are options and how do they work?

Option  is a financial contract concluded between two parties - the holder and the seller. The former gets the right, but not the obligation, to buy or sell a certain amount of the underlying asset at the strike price (strike price) on a specific date (expiration date).
The seller agrees to buy or sell the asset at the request of the option holder. The latter pays the seller at the time of purchase of the contract a certain amount of money - the so-called  premium .
The rights and obligations of the holder and the seller differ significantly. The first has the right to choose whether to exercise the option or not. The seller is obliged to fulfill the terms of the contract at the request of the holder.

Parameters such as the type of the underlying asset, expiration date, strike price are fixed at the time of the release of the contract, after which they cannot be changed.
Like futures, options are financial derivatives, derivatives. This means that they can be based on various underlying assets (BA) - stocks, indices or cryptocurrencies.
“Similar to the options for all major assets already existing in traditional finance, there are contracts on the basis of BTC and ETH in the cryptocurrency market. They are very interesting financial products, ”said Su Zhu, head of Three Arrows Capital.
Options are used for both risk hedging and speculative trading. For example, a speculator who is confident in the growth of the underlying asset buys a call option. If the BA price rises above the strike, the trader can use his contract to buy the asset at a discount.
“Derivatives such as options allow users to hedge risk and generate income. In the traditional financial market, derivatives play a key role. These tools are needed for the cryptocurrency market to continue to grow and develop with new entrants, ”said Aaron Gong, Vice President of Binance Futures.

Practical use of options

Let's look at the simplest example of hedging using options. Let's say there is a company that makes tomato paste, sauces, and ketchup. There is a farmer supplying tomatoes to this company. It operates in a highly competitive environment that is close to  perfect .
It is extremely important for a company to buy cheaper raw materials in order to minimize production costs and remain in profit. The farmer, in turn, hopes for a long-term cooperation with the company so as not to lose a large client.
The company offers the farmer an option to buy 10 tonnes of next year's harvest tomatoes at today's current price - say, $ 1,000 per ton. To exercise this right, the company pays the farmer an option premium - 3% of the total transaction amount of $ 10,000, that is, $ 300. The farmer will, at the request of the company, have to sell the corresponding quantity of the product at the above price and within a specified time frame.
A year later, the harvest was high, which led to a decrease in the market value of tomatoes to $ 800 per ton. The company decides not to exercise its right to purchase raw materials for $ 10,000, since the same 10 tons of tomatoes can be purchased from other farmers for only $ 8,000.
Thus, having lost only $ 300 in option premium, the company is insured against price risk. The purchase of raw materials at a significantly lower market price more than pays for the cost of the option contract.
Let's imagine another scenario: the harvest turned out to be poor and the price of scarce tomatoes jumped to $ 1200 per ton. Then the company will certainly use the right to purchase tomatoes for $ 1000. Thus, there is a benefit in any development of events.
It is easy to guess that options can be used by miners to hedge the risks of an unfavorable change in the price of a mined asset. For example, while waiting for the price of BTC to decrease, miners can use options that give the right to sell cryptocurrency in the future at a value above the break-even point.
“Miners are already very active in the options markets. And, probably, they will remain active, ”Su Zhu stressed.
He added that the growing popularity of such contracts among miners could significantly reduce the selling pressure.
“Options give miners the opportunity to fix the price of coins mined in the future. Miners can better manage their production costs and protect themselves from market volatility, ”said Aaron Gong, expressing confidence that the popularity of options will continue to grow.
According to him, such tools open up new opportunities and may be of interest to speculators, funds and long-term holders of cryptocurrencies.
“Institutional investors are also showing growing interest in options and other derivatives. It was reported last week that renowned Wall Street trader Paul Tudor Jones has allocated a few percent of his Tudor BVI fund for bitcoin futures. This is a positive signal, which means that more and more institutions are interested in the cryptocurrency market, ”added Gong.
Su Zhu is confident that in the long term, options will make the cryptocurrency spot market more liquid and attractive for a wide range of participants.

Types of options

There are two basic types of options -  call option  and  the put options . The first gives the contract holder the right to purchase a certain amount of the underlying asset from the seller (they also say - the  writer ,  writer ) at the execution price for a certain date in the future. It is this type of option that was used in the tomato example.
Call option yield graph depending on the price change of the underlying asset. Strike price = 100, option premium = 10. Source:  wikipedia
Conversely, a put option gives the buyer of the contract the right to sell the underlying asset at a fixed price. The latter can be higher than the market at the time of expiration, which is beneficial for the trader.
Market participants use a call, predicting an increase in the BA price, and a put - expecting it to decline. More complex strategies use combinations of these two types of contracts.
There is also the term  "covered option" . For example, a call option is covered if the seller has the amount of the underlying asset that meets the contract.
Also, options may differ in  style of execution  - American or European.
European-style options are   intended to be exercised by the holder of the contract solely on the expiration date. Such options, in particular, are presented at CME and Bakkt.
The American style  assumes the possibility of contract execution at any time before the expiration date. Both styles are traded all over the world, and their names have nothing to do with georeference.
There are also less standardized,  exotic  options. However, the popularity and significance of such instruments in the financial market is not so great.
The parameters and conditions of trading certain options are described in the  specifications  for them, which indicate the expiration date, strike price and other elements of the contract.
Below is a screenshot of the OKEx bitcoin options page:
Data as of 12.05.2020
The  main parameters of the option are highlighted in green - a contract for a pair of bitcoin / US dollar; "20200515" - the expiration date of the contract is May 15, 2020. 9000 - the strike price of the asset used for comparison with the base price. "C" stands for call, that is, a call option. In the case of P, it would be a put option.
The  yellow box contains  important optional metrics:
  • “Index (USD)”  - a spot index that affects the option price; this is the marker price used by the exchange to calculate the base bitcoin rate and which the investor should be guided by;
  • “Market Price (BTC)” is  calculated by the platform's algorithm in real time; so to speak, the "fair" price of options.
The  order book familiar to any trader is marked with a blue frame . Sell ​​prices are shown in red, buy prices in green, and the number of contracts on the right.
OKEx offers European style options with a minimum order size of 0.1 (the same as the segment leader Deribit). Detailed specifications can be found  here .

Premium, strike price and option monetary value

The option premium  is the amount of money paid by the buyer to the seller. The premium is equal to the value of the contract and is essentially a payment for the risk of an adverse change in the value of the underlying asset.
The option premium is formed by two components:
  • The intrinsic value  is the amount that the buyer would receive if the contract was executed at the moment. It depends on the ratio of the price of the underlying asset to the strike.
  • Time value  - depends on the time remaining until expiration. Usually, the shorter the time until the contract is executed, the lower the premium.
As a rule, high price volatility promotes premium growth, and vice versa. A trade with a close strike price in relation to the current one has a much higher chance of closing in profit and, therefore, the premium on such an option will be relatively high.
The table below illustrates the effect of various factors on the option premium:
The strike price  or  strike price  is the value fixed in the option at which the buyer of the call option  can  buy (or sell, if it is a put option) the underlying asset. In turn, the seller of the contract is  obliged to  sell or buy BA.
Cash  is an indicator of the ability to receive funds from the exercise of the right to execute a derivative. In the context of options, the monetary value can be calculated by comparing the BA spot price and the option strike price. Thus, three options are possible:
  • in-the-money option  : in the case of a call - if the spot price is higher than the strike (then the intrinsic value of the contract is positive), in the case of a put, on the contrary, - if the BA price is lower than the strike;
  • option  "on the money"  (or "at own") - equality of the strike to the current exchange quotes, the intrinsic value is equal to 0;
  • option  "out of the money"  ( "free money") - exercise of the option is not economically feasible; in this situation, the current price of the underlying asset is lower than the strike price of the call option, or, conversely, the spot price of the BA is higher than the strike price in the case of a put.
The table below shows the options for pricing call and put options in terms of monetary value.
Thus, when the option expires, its out-of-the-money value will be 0. The in-the-money contract value will correspond to the difference between the strike price and the BA price, or the so-called intrinsic value of the option.

Option strategies

There are many options trading strategies. Four basic approaches can be distinguished.
Long call  - when buying a call option, the investor expects the price of the underlying asset to rise above the strike on the expiration date of the contract. Then he will be able to buy the asset at a discount to the market price and thus make money on the difference. If the price drops below the strike, the buyer risks only the premium paid for the option.
A long put  is a kind of alternative to a short position in the spot market. The buyer of the put option hopes to make money, assuming that the BA price drops below the strike at expiration. In this scenario, the investor can sell the asset at a higher price than the market price.
Also, using a put option, an investor can limit the risk of a fall in the price of an asset for which a long position is open. According to Su Zhu, the strategy of "protective puts" can be used by miners, in whose activities it is undesirable for a significant and prolonged fall in the price of the mined cryptocurrency. Through such tools, miners can provide profitable or at least break-even activities.
Short call  The investor acts as the seller of the contract, counting on a decrease in the BA price below the strike on the expiration date. However, the higher the price of the asset, the more losses are incurred by the inscription. Thus, the seller's risk is unlimited, and the profit potential is limited by the premium from selling the call.
Short put.  The seller of such an option is counting on a premium on it, being firmly convinced that the BA price will be higher than the strike.
Combinations of these basic strategies can underlie more sophisticated approaches to options trading, such as:
  • protective put  - buying a put option for an available asset;
  • covered (secured) call  - the investor sells a call option on an existing BA or which will be purchased simultaneously with the option sale; the strategy reduces the risk of owning the asset, since the fall in its price is partially offset by the premium;
  • straddle  - a kind of volatility bet that involves buying a call and a put option on the same asset with the same expiration date and the same strike price;
  • strangle  - almost the same as straddle, differ only in different strike prices.

The current state of the cryptocurrency options market

The aggregate open interest (OI) for bitcoin options reached an all-time high of $ 800 million by the end of April 2020, and exceeded this mark in May.
Source:  The Block , skew.
This market segment is dominated by Deribit, accounting for almost 85% of the OI. This exchange is closely followed by OKEx and regulated LedgerX. Bakkt's market share is negligible.
Data:  skew  as of 05/12/2020
On May 8, OI on Deribit surpassed $ 1 billion.
Deribit's trading volume exceeds OKEx by more than 10 times:
Data:  skew  as of 05/12/2020.
The following screenshot illustrates that Deribit is dominated by put options, with the highest OI for contracts expiring on May 29 at a $ 7,000 strike price. This type of option is probably popular with hedgers who allow the price of BTC to return to lower levels.
Data:  skew  as of 05/12/2020
Call options with a strike of $ 12,000 and expiration on June 26 have a much lower OI.
Bitfinex planned to offer options to the market back in the first quarter. The launch of these futures contracts at the beginning of last year was considered by the BitMEX crypto derivatives platform.
Su Zhu said that successfully entering this market is not an easy task. The above platforms offer simpler derivatives, but options are a completely different level.
“The main difference between options and, say, perpetual contracts or spot contracts is the much higher technological requirements for the exchange, which needs to execute such orders. Here one or two and it will not work out, "- the expert shared his opinion.
 Simplified American-style short-term options appeared on Binance in April  Only the exchange can act as a label for these instruments, but not the user. The latter is thus assigned only the role of the buyer.
When asked if Binance could gain significant market share in the foreseeable future, Zhu replied:
“I think their options are definitely targeted at retail traders using mobile apps. Deribit is more for advanced market participants. "
Thus, for now, Deribit is practically a monopoly on the bitcoin options market. However, it will be interesting to see if Binance and other players manage to gain any significant share of the segment over time.

conclusions

Options are complex financial instruments; most novice traders are unlikely to immediately master their mechanism of operation. Nevertheless, these derivatives may seem interesting to experienced market participants and, in particular, miners.
The following advantages and disadvantages of options can be distinguished. Of the  advantages of  these contracts, we note:
- flexibility of use in speculative trading;
- the ability to use a variety of combinations and trading strategies;
- a good tool for hedging risks;
- the ability to use in any trend - upward, downward, sideways.
Disadvantages:
- the complexity of understanding the mechanism of work, especially for novice market participants;
- asymmetrical conditions and, accordingly, risks for the buyer and the seller;
- the complexity of trading strategies;
- volatility of the option premium, which depends on the proximity of the expiration period and price dynamics in the spot market;
- low liquidity.
Different industry players have different attitudes towards cryptocurrency-based options. Some consider them to be promising tools useful for miners, funds, retail traders and the market in general. Others are convinced that such derivatives are archaism.
Nevertheless, options are gradually taking root in the cryptocurrency market. This can be seen from the dynamics of the trading volume and open interest. In addition, more and more exchanges are looking to add support for these contracts, which will increase competition and further develop the industry.

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