How Crypto Options Work?

Styles of Crypto Options:

• American: Allows the buyer to exercise the contract at any time before the expiry date.
• European: Allows the buyer to exercise the contract only at the expiry.

It's important to note that European-style options, while only exercisable at expiry, can still be traded or closed out early by the buyer.

Types of Options:

• Call: The right to buy the underlying asset.
• Put: The right to sell the underlying asset.

Options Trading Process:

An options seller "writes" (creates) call and put options contracts, each with an expiration date and a "strike price," which is the price at which the contract buyer can buy or sell the underlying asset upon expiry (or before if it’s an American-style option). The seller then lists the contracts on a crypto options exchange. Alternatively, a buyer can place an order on the exchange, and a seller can sell it.

The cost of an option is known as a "premium." Similar to insurance, this premium provides protection; for example, a put option serves as downside protection. If the price of the underlying asset falls below the strike price, the options writer is obligated to buy the asset from the owner at the fixed price.

The premium's price depends on several factors:

• Time remaining on the contract.
• Implied volatility (the expected price fluctuation of the underlying asset during the contract period).
• Interest rates.
• The current price of the underlying asset.

The current price of the underlying asset significantly affects the premium cost:

• In the Money (ITM): For a call, when the strike price is lower than the current price of the underlying asset; for a put, when the strike price is higher.
• At the Money (ATM): When the strike price is equal to the current price of the underlying asset for both calls and puts.
• Out of the Money (OTM): For a call, when the strike price is higher than the current price of the underlying asset; for a put, when the strike price is lower.

A trader buying a call option with a strike price lower than the current market value of the underlying asset will pay a higher premium because the contract is "in the money" and has intrinsic value. However, this does not guarantee that the price will remain above the strike price until the contract expires.

Example:

• Scenario: The price of one bitcoin at the start of January is $34,000. Bob believes the price will be higher by the end of February, so he buys 10 European-style call options with a strike price of $36,000, each costing a 0.002 bitcoin premium, expiring on February 28.
• Premium Cost: 0.002 bitcoin at $34,000 = $68 per contract. 10 contracts = $680 total.

Each contract gives Bob the right to purchase 0.1 bitcoin at $36,000 per coin, allowing him to buy one bitcoin at $36,000 when the contract expires.

• Scenario A: At expiry, bitcoin’s price is $40,000. Bob exercises his call option and makes a $4,000 profit (40,000 - 36,000). After deducting his premium, he walks away with $3,320.
• Scenario B: At expiry, bitcoin’s price is $32,500. Bob does not exercise his call option as it’s "out of the money," resulting in a loss of $680, the premium paid.

Understanding Option 'Greeks'

Option Greeks refer to four factors that influence the price of an option premium, derived from the Black-Scholes Model, a method created in 1973 by Fischer Black, Myron Scholes, and Robert Merton to standardize option pricing. The model is widely used for European-style options, while American options use other methods like the Binomial model.

The Greeks are:

• Theta (Θ): Represents the amount of time left until the option expires. More time means a higher option price.
• Delta (Δ): Measures the change in the option's price given a change in the underlying asset's price. It ranges from 0 to 1 for calls and 0 to -1 for puts.
• Gamma (Γ): Indicates the rate of change in Delta as the underlying asset’s price changes.
• Vega: Tracks the expected volatility of the underlying asset. Higher volatility increases the option's price.

Selling 'Naked' Call and Put Crypto Options

Going "naked" with options means taking an options position without holding the opposite position in the underlying asset.

• Naked Call: Selling a call option without owning the underlying asset, essentially shorting the asset.
• Naked Put: Selling a put option without selling the underlying asset, effectively being long on the asset.

Selling naked options is risky and can lead to significant losses. Typically, sellers own the underlying asset to cover potential losses. For example, if an options seller owns the asset, they can mitigate losses if the price moves against them.

Example Scenarios:

1. Covered Position:

• The seller does not own Bitcoin.
• If Bitcoin rises to $40,000, the seller's loss is $3,320
  • -$4,000 loss from buying Bitcoin at $40,000 to sell at $36,000 (strike price)
  • $680 gain from the option premium.

Despite the risks, some sellers choose naked options to avoid investing their own capital upfront, as they stand to gain in two out of three scenarios:

• The underlying asset's price moves in the buyer's favor, and the seller loses money.
• The price remains the same, and the buyer does not exercise the contract.
• The price moves against the buyer, and the buyer does not exercise the contract.

Sellers must calculate the risks based on the underlying asset's volatility to decide if earning premiums without upfront investment is worth it.