Options contracts are agreements between two parties. An option gives the holder the right, but not always the obligation, to buy or sell an asset at a certain price on or before a specific date. Some exchanges also offer what are called binary options, where traders place bets on which way the price of an asset will move.
Bitcoin options are a popular way for both retail and institutional investors to profit from the price movements of Bitcoin. Here are the basics of how Bitcoin options trading works.
Bitcoin Options Defined
A Bitcoin option is a derivative — a financial instrument that derives its value from an underlying asset. A Bitcoin options contract is an agreement to be able to buy Bitcoin at a certain price on a certain date.
In the early days of Bitcoin, the only way to acquire the asset was either to mine coins yourself or buy them from someone who did. Over time, reputable, trusted exchanges popped up, and the market cap and daily trading volume of Bitcoin began to grow rapidly, along with its price. This began to attract the attention of institutional investors like banks and hedge funds.
But because Bitcoin existed in a legal grey area devoid of any real regulations, institutions couldn’t touch it. They couldn’t risk getting in trouble with regulatory authorities like the SEC, CFTC, or FINRA. They wanted a way to get into the market in a more indirect, regulated way.
So they pushed for the creation of crypto derivatives like Bitcoin options.
Explaining Bitcoin Options Trading
For the most part, Bitcoin options trading works like trading options for any other asset. There are some key differences, including the following:
• Most Bitcoin options are cash-settled, meaning there’s no delivery of the underlying asset
• Bitcoin options tend to be very volatile, so they have high implied volatility (IV)
• Due to the high IV, these contracts tend to come with high premiums, making them expensive to trade
How Are Bitcoin Options Traded?
The simplest types of options on Bitcoin are calls and puts. A call gives the holder the right to buy Bitcoin at a certain price on a specified date. A put gives the holder the right to sell Bitcoin at a certain price on a specified date. There are also more complex strategies for trading options that won’t be covered here.
While trading Bitcoin options might sound simple, the actual process can get confusing. Most exchanges make it easy enough to pick a strike price, expiration date, and call or put. So, almost anyone can buy a contract.
But understanding how different variables affect the price of the option can be a lot more complicated. It’s not uncommon for new options traders to lose money. Losses can be much larger than anticipated, too.
Put options in particular come with unlimited risk. There’s no limit to how high the price of Bitcoin, or any other asset, can potentially go. And the further the price rises, the more money a put option holder will lose.
What Drives Bitcoin Options Prices?
There are a few main factors that make up the price of an option. It’s crucial for options traders to be familiar with these terms and to research how they apply to the specific options contracts they want to trade.
Expiry Date
This is the date the option will be exercised. For calls, the option holder can buy the underlying asset on this date. For puts, they can sell.
Strike Price
This is the price of the underlying asset that the option holder can buy or sell at upon expiration.
Time Decay
As the expiry date approaches, time decay settles in. This erodes the premium of the contract, decreasing its value over time. Because there is less time for prices to move, and therefore less opportunity to profit as expiration draws near, no one is willing to pay very much for the contract any longer. Time decay is not a linear process; it gets increasingly faster the closer it gets to the expiration date.
Implied Volatility
The more volatile the underlying asset, the more uncertain the outcome of a contract will be. This makes the contracts more expensive. Sometimes, implied volatility can collapse even as the price of an asset moves in the direction a trader wants it to — resulting in “IV crush”. The value of a contract can then decline quickly. This is just one way that options traders can get crushed even when they make the right bet.
Premium
This is the price that someone pays to buy the option. How the premium is calculated depends on the other factors.
Of course, anyone trading options would also be wise to understand the underlying asset of the contract. In this case, they might want to learn what Bitcoin is beforehand.
When Do Bitcoin Options Expire?
Bitcoin options are European-style contracts, meaning they can only be exercised at expiration. In contrast, American style options can be exercised at any time.
Like other options, Bitcoin options expire on their expiration or expiry date. This time can also be referred to as the option “reaching maturity”.
In general, options with an expiry date further into the future come with higher premium prices. This is due to the added uncertainty. With more time until maturity, the writer (seller) of the option is taking on a greater risk, because there’s more time for the underlying asset to make a big move one way or another.
As a result, the options writer will demand a higher premium. There is also more time for buyers of the option to make a profit, so they are willing to pay more for the contract.
How Expensive Are Bitcoin Options?
Because of their implied volatility, Bitcoin options tend to be among the most expensive options contracts on the market. The higher the IV, the higher the premium, or price of the option.
Bitcoin itself has a reputation for being among the most volatile assets in the world. The only thing more volatile might be altcoins, other cryptocurrencies with smaller market caps. Because of that extreme volatility, Bitcoin options tend to be much more expensive than options that have more traditional underlying assets like bonds or equities.
It’s hard enough to answer the question “how is Bitcoin valued.” Determining how Bitcoin options are valued can be even more difficult.
Bitcoin Options and CME
The Chicago Mercantile Exchange (CME) Group is a leader in trading options and futures. About 50 years ago, CME Group was responsible for creating the first futures contracts that had financial instruments as the underlying assets rather than commodities.
It’s perhaps fitting that the CME Group also launched the first regulated Bitcoin futures exchange in the USA in the fourth quarter of 2017.
The Takeaway
Bitcoin options trading can be complex, confusing, and risky. As with any options trading, there are multiple factors that can lead to unexpected changes in the value of a contract. Even if the price moves in a direction that is favorable to the contract, traders can still lose money due to changes in time decay and implied volatility.
Photo credit: iStock/Eoneren
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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