Bitcoin Options: How Do They Work?

The cryptocurrency market has been actively developing for years. Besides simple holding cryptocurrency or spot trading, there are other ways to earn money in crypto. One of them is trading crypto derivatives, which are a parallel to the traditional derivative products.

Derivatives are financial instruments, which represent contracts between at least two parties. They derive their value from other assets (called the underlying assets). The first popular type of derivatives is futures, while the second — options on Bitcoin.

In this guide, we will explore how Bitcoin options work, what kinds of options there are, and how they can be useful for crypto investors.

Intro to Crypto Options Trading

Options’ features make them very useful in advanced trading strategies that cannot be implemented in the spot market. That said, they are quite a complex tool, usually used by experienced traders. However, options trading is worth mastering. A trader acquires both speculative and hedging opportunities, which help to build more flexible and consequently profitable trading strategies.

Options Trading Definition

A Bitcoin option is a derivative financial instrument which represents the underlying asset — Bitcoin. Essentially, it is a contract between the seller and the buyer. It gives the right (but not the obligation) to purchase an asset at a predetermined strike price at the time of expiration of the contract.

By trading options, the trader chooses between buying “Call” and “Put” options. A Call option gives its holder the right to buy BTC at an agreed-upon price at the time of expiration of the contract. Conversely, a Put option gives its owner the right to sell BTC. In both cases, however, it is up to the option holder to decide whether to exercise the right to buy BTC or not.

In order for the options to be profitable, the rate of the cryptocurrency must move in the direction, beneficial for the trader. If the investor purchased a Call and the BTC price is declining, then the option loses in value. However, an important feature of options is that they allow calculating potential losses at the moment of the purchase. If the contract purchase price is $100, that will be the maximum loss.

How Crypto Options Differ From Traditional Markets

Cryptocurrency options employ the same concept as traditional options, but their underlying assets are cryptocurrencies such as BTC, ETH or BNB.

Like traders in traditional markets, crypto traders enter into options contracts for two reasons: speculation and hedging.

But while traditional options and crypto options share a lot of similarities, there are three main differences between them:

1. Regulation. While traditional markets generally obey laws and standards designed to ensure the legitimacy of trading, protection against fraudulent behavior, market manipulation and so on, regulation has only recently come to the cryptocurrency market.

2. Trading hours. Stock markets, for example, are closed for 13.5 hours each day, which is not always convenient, especially for traders who trade on the news. At the same time, trading crypto assets is available at any time of the day, on any day of the year.

3. Size and volume of trading. In terms of value and volume, traditional markets are much larger than cryptocurrency exchanges. Also, crypto-option markets have relatively less institutional involvement and are largely dominated by retail investors.

Bitcoin vs. Bitcoin Options

There are a number of fundamental differences between buying Bitcoin directly and buying a Bitcoin option. For instance, by holding an option you do own BTC directly, which deprives you of certain possibilities, such as using Bitcoin for payments or for wealth accumulation. Therefore, trading option contracts requires a different approach than simple Bitcoin trading.

Hedging

Options are one of the primary tools to protect your portfolio from market risk and price uncertainty. Buying Bitcoin puts allows the trader to inexpensively hedge against market declines and thus protect themselves against volatility or market crash.

A useful feature of options is that the trader can choose the contract duration to protect the portfolio for one day, a week, or even several months in the future.

Price Speculation

Options are a great tool for speculative transactions. Compared to spot traders, option traders can make significant profits from the changes in the price of BTC without investing a lot of money in Bitcoin itself. You are risking only the money you spent to buy the option (the premium).

The Benefit Of Leverage

Bitcoin options, like futures, are leveraged products. It means that you may potentially generate higher returns even with little capital. However, unlike futures which offer the manual selection of the leverage level, options have an implicit leverage. The higher the marker volatility, the larger options’ leverage and potential returns. At the same time, risks increase, too.

Expiration Dates

Expiration of options is the process of completion of their circulation on the exchange. On the date of the expiration, the option contracts are exercised.

Note that some Bitcoin options can be exercised not only on the expiration date, but also before the expiration. So, depending on their expiration conditions, BTC options are divided into styles, which we will break down below.

European-Style Options Contracts

European-style option contracts can be exercised only on the expiry date. In case the price of the underlying asset moves into the unforgivable direction for the trader, they won’t be able to exercise the contract early.

American-Style Options Contracts

American-style is an option contract that can be exercised by the holder on any day prior to expiration. That is, if redemption can be made all the way up to a set day, then the option is called an American-style option.

How Bitcoin Options Trade

Trading options on Bitcoin is not fundamentally different from trading options on any other asset.

For example, you buy a Call option on BTC with a strike price of $20,000 that expires in one month. So, in a month, regardless of the price, you have an opportunity to buy one BTC for $20,000. The premium you pay to the option seller equals $1,000.

If the price of Bitcoin in a month will be $30,000, then it will certainly be profitable for you to use your right and buy BTC at the agreed price of $20,000 and then sell it at a profit of $10,000. Your profit on the deal will be $9,000.

And if the price of BTC goes down to $10,000, you would be better off just letting your option expire. Because buying BTC at the strike price would result in a loss. You can simply buy BTC at $10,000 instead of $20,000. And if you do not exercise the option, your loss on the trade will be equal to the premium you paid, that is $1,000.

Why Are They So Expensive?

The price of options (premium) is determined by the market and is based on intrinsic and extrinsic value. The intrinsic value is the difference between the BTC spot price and the strike price of the option, but only when the value is positive for the option holder. When an option is disadvantageous to the buyer, it is said to have zero intrinsic value and only external value, such as time value, strike price and volatility.

When an option is “in the money” — it means option holders will benefit from the exercise of their option. In this case, the option has intrinsic value. Such an option is easier to evaluate because the intrinsic value is established, and the extrinsic value is a function of the risk associated with time value and volatility.

An “out-of-the-money” option has no intrinsic value, so its price is entirely dependent on these external value factors. Therefore, the option price (premium) cannot be too low, as the option seller takes significant risk, especially in the case of a volatile asset such as Bitcoin.

Essentials of Bitcoin Options Trading

Now that we've covered the basic concepts of Bitcoin options, let's understand the specifics of options trading and how option contracts are used to make a profit.

Holding and Writing Options

An option contract always includes two sides. One side is the buyer of the option and the other side — the “writer” or seller. When the trader decides to buy and “hold” an option, they are obliged to pay a premium. It gives him the right to buy or sell BTC in the future.

When a trader decides to “write” an option, he/she creates a new option contract and sells someone the right to buy or sell BTC. In other words, the seller of the option can be forced to buy or sell BTC at the strike price. But for this risk, the option seller gets the premium paid by the option buyer. The amount of the premium received when an option is sold depends on the current BTC price, the expiration date of the option, and other factors, such as the volatility of the underlying asset.

Bitcoin Call Options

A Call option gives the holder the right to purchase a certain amount of BTC at a predetermined price by a specific date. This type of option enables traders to profit if the price of the asset increases until the expiration date.

In case the Bitcoin spot price is lower than the strike price, it would be unprofitable to buy the BTC at the price specified in the option, as it will be possible to buy it cheaper in the market. This is why the option implies that in this case, the buyer of the option has the right to refuse to fulfill the contract.

Bitcoin Put Options

A Put option gives the holder the right to sell a certain amount of BTC at the strike price on a certain date. This type of option allows making a profit from falling prices.

In case the spot price of Bitcoin is higher than the strike price, it would be unprofitable to sell the BTC at the agreed price, as it can be sold at a higher price in the market. The option buyer in this case also has the right to refuse to exercise the contract.

The Greeks

“Greeks” are a set of parameters used by traders to manage risk and predict potential returns from an option strategy. They show the trader how an option will respond to changing market conditions at different points in time.

Delta shows how much the option price reacts to a point change in the underlying Bitcoin price.

Vega tells the trader how much they can expect the option price to change if the implied volatility changes by 1%. Implied volatility is a measure of how much the asset will fluctuate in the future.

Gamma shows how much a Bitcoin option's delta will change for each point (e.g. $1) change in the underlying Bitcoin price.

Theta measures the rate of change in the option's premium relative to time — specifically, how much value the option will lose due to time-lapse over the next 24 hours.

Rho shows the reaction of the option price to a change in the risk-free interest rate (usually on U.S. Treasury bills).

Managing Risk With Options

When you buy options on Bitcoin, your maximum loss is equal to the amount of premium paid for the option. That is, no matter how far out of the money the option closes, the trader will not be able to lose more than he/she paid for it. So, basically, the rule of “never invest more than you can afford to lose” is enforced. Due to this nuance, the trader will never incur heavily losses and will never find themselves in debt.

Covered vs. Uncovered

A Covered Call is the sale of a Call option contract on an asset that you already hold. The long position in the asset serves as the cover, because it can be used to deliver the assets on the exercised option. Conversely, an uncovered option is selling an option when you have no underlying asset. In this case, you are required to have an option margin.

Option Margin

When buying a Call or Put option, the buyer only has to pay the premium. At the same time, when selling an Uncovered Call option, a maintenance margin is required. It serves as a guarantee that the seller will fulfill their obligations in case the option is exercised.

Notably, Uncovered options on BTC are rarely seen on cryptocurrency exchanges and are used mostly by large institutional traders.

Pros and Cons of Bitcoin Options

Bitcoin options trading comes with its own advantages and disadvantages. It can be beneficial to the trader for several reasons:

• Limited risk, equal to the premium paid to the seller, with theoretically unlimited returns;
• Resistance to short-term volatility, as only the price of the underlying asset on the expiration date matters for profit.

The disadvantages of options are as follows:

• High difficulty for beginners, as one should be able to choose the type of option, the expiration price, analyze the size of the premium and other important indicators;
• Not available on all popular cryptocurrency exchanges;
• Lower liquidity than on the spot market.

Conclusion

Options on Bitcoin are complex financial instruments and their mechanism is quite complicated for most novice traders. However, they combine the high profit opportunities with low risks. And with a smart trading strategy and correct market analysis, the risks can be further significantly reduced.

FAQ

What are the Benefits of Trading Bitcoin Options?

Many investors prefer to trade Bitcoin options due to the high potential earning and limited risks. Also, unlike spot trading, they allow profiting on any trend: upward or downward.

Are Bitcoin Options A Good Investment?

Bitcoin options are a good way to speculate on price changes, even on the declining trend. However, options are more suitable for experienced traders with a well-developed strategy.

* This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.