Alongside bitcoin futures, options contracts on bitcoin constitute another popular product that both individual and institutional investors want to trade. In fact, according to TokenInsight, options trading volume has increased from $8 billion in the first quarter of 2020 to $45 billion in the fourth quarter, and $77.2 billion in trading volume for the whole of 2020.

As such, options on digital assets have played an important role in the crypto space while providing multiple use cases for traders and investors.

What are Cryptocurrency Options?

An options contract is a type of derivative that represents an agreement between two parties to facilitate a potential trade in an underlying asset at a predetermined price, known as a strike price, by an expiration date.

While derivatives can cover a variety of instruments – such as stocks, bonds, commodities, currencies and market indices, in the case of cryptocurrency options, the underlying asset is Bitcoin (BTC), Ethereum (ETH) or other digital assets.

Digital asset options and futures contracts are very similar in that they both represent an agreement between two parties with a cryptocurrency as the underlying asset.

However, while in the case of futures, buyers and sellers are obliged to fulfill their promises, contract holders are not necessarily exercising their rights to trade assets on the expiry date.

The buyer (contract holder) buys the option from the seller (seller) at a premium. Even if the buyer chooses not to exercise his rights, he still has to pay the premium.

The premium price depends on several factors, including the value of the asset, the strike price, volatility and the length of the contract.

Higher volatility levels push up premiums; shorter time frames are cheaper. The reason for the latter is that the chances of price moving in the trader's favor are lower on shorter time frames.

According to the products of brokers and crypto exchanges, we divide options into two types. European options and American options.

American options allow the holder to exercise their rights at any time before the contract ends, while European options are more restrictive.

Like other derivatives, crypto options traders can use leverage to trade, increasing their risk. This can mean magnified profits, but highly leveraged positions can also greatly increase risk.

In addition to increasing profit potential, traders can use crypto options to stabilize price volatility, hedge market risk, and short digital assets.

Fundamentals of Cryptocurrency Options

You can trade cryptocurrency options in two forms: calls and puts.

Call options offer buyers the opportunity to buy a digital asset at a predetermined strike price, while put options allow the holder to sell the cryptocurrency at a given strike price.

Below, we list four examples of cryptocurrency options trading in the market to understand their rationale.

buy call option

Buying a call option is meant to signal bullish sentiment, as the holder expects the value of the underlying digital asset to increase in the near term.

By purchasing a call option contract, the buyer can protect himself from high volatility.

For this reason, instead of buying the digital asset on the spot market, the trader hedges his position with call options. Therefore, the only risk he faces is the option premium he pays to hold the contract.

If at the expiration date, the value of the underlying asset has risen significantly compared to the strike price, the holder can exercise his right to make a profit.

On the other hand, if the value of the cryptocurrency is lower than the strike price, the holder can refuse to execute the transaction to reduce the loss (although he still needs to pay the premium cost).

buy put option

Buying a call option is a signal of bullish sentiment, so when buying a put option, it indicates that the holder believes that the price of the underlying asset will fall.

However, unlike shorting cryptocurrencies, put option holders are immune to a sudden increase in the value of the digital asset.

In this case, the put option holder can not exercise the contract until the expiration date and only pay the premium price as a loss.

On the other hand, when the spot price falls below the strike price, the buyer makes a profit that is greater than the premium paid for the contract.

sell put option

Interestingly, traders who forecast a bullish price can also profit by selling put options.

When the spot value of the cryptocurrency is higher than the strike price, the buyer of the put option will choose not to execute the trade, so the seller will profit from the premium.

However, while the premium offers option sellers more potential for profit, unlike buyers, they are obligated to trade the underlying asset when the holder decides to exercise their rights before the expiration date.

Therefore, option sellers are not as protected from losses as buyers (although they can still make money from the premium).

sell call option

Similar to buying put options, selling call options also offers traders an opportunity to benefit from bearish price movements.

Like selling a put option, buying a home generates a profit from the premium when the buyer does not exercise his right to trade the asset.

However, call option sellers only profit if the asset's spot value falls below the strike price.

Instead, they must execute the trade and take the loss.

Top 3 Most Popular Strategies for Cryptocurrency Options Trading

One of the main advantages of crypto options is the high degree of flexibility that traders can take advantage of various strategies.

Below, we list three of the most popular cryptocurrency options trading strategies:

Protective put: A trader uses a protective put strategy when he already owns the underlying asset. To hedge against a potential bearish price movement, you purchase a put option with a strike price that is the same or close to the current value of the digital asset. In case the price of a cryptocurrency falls, you can exercise your right to sell options at the strike price, which will cover most of your losses. Conversely, if the asset increases in value, you don't need to execute the trade and only take the premium as a loss.

Covered call: A covered call means that a trader holds digital assets while selling call options. Therefore, you can earn additional premium income when the price is bearish because the buyer will not execute the trade. Conversely, your holdings will cover the loss of selling the call option. That's why this strategy is called a covered entry.

Straddle: A trader simultaneously purchases a call and a put option with the same strike price and expiration date. The move might seem counterproductive at first, as you are simultaneously betting on a fall and rise in the price of the same underlying asset. However, when the market is volatile enough that the up or down gain exceeds the total amount spent on premiums, a straddle strategy allows you to profit from extreme price moves in either direction.

How Options Trading Affects Cryptocurrency Markets

Cryptocurrency options trading rarely has a direct impact on the spot price of the underlying cryptocurrency.

However, a large amount of funds are concentrated in out-of-the-money options (OTM) that are nearing expiration, that is, call options with a strike price higher than the spot price and put options with a strike price lower than the spot price, which will suddenly increase market volatility and affect the underlying the price of the asset.

If the overall market sentiment is bullish, it means that calls are the main form of options on cryptocurrencies.

In a bullish scenario, market makers (those who provide liquidity to exchanges) may hedge OTM call options they sell to buyers to buy the underlying asset before expiration.

Doing so could create more volatility when a large number of OTM options expire within a short period of time and further push up the price of the cryptocurrency.

Crypto Options: An Important But Still Early Stage Crypto Derivative

Crypto options are gaining popularity, but are still in their early stages, especially when we compare their trading volumes to digital asset contract futures trading volumes.

While 2020 recorded a volume of $77.2 billion, contract futures traded $12.31 trillion during the same period.

AAX is a digital asset exchange powered by London Stock Exchange Group technology. AAX Vision is a blockchain industry observation channel created by AAX, which aims to help more users broaden their horizons and learn more about blockchain news.

About AAX Horizons

AAX is a digital asset exchange powered by London Stock Exchange Group technology. AAX Vision is a blockchain industry observation channel created by AAX, which aims to help more users broaden their horizons and learn more about blockchain news.