What is Options Trading & How does it work?

What is Options trading?

Options trading is the process when traders using these complex instruments to participate in the DeFi space. In which traders have the right to buy or sell a specific asset with an expiry time and a specific price.

Options are a form of tradable derivative contract that permits users the rights to speculate about whether an asset’s price will be higher or lower at an expiration date, without any obligations to actually buy or sell the asset in question.

Options can be settled in a variety of assets such as stablecoins or actual cryptocurrencies (BTC, ETH, etc) that CEXs support. While it is a little more complicated than stock trading, options trading can help users gain larger profits through leverage or limit heavy losses by hedging.

Options related terms

To trade Options, these are some related term you have to know:

• Strike price and expiration date: The determined price is known as the strike price. Traders have until an option contract’s expiration date to execute the option at the strike price.
• Premium: The cost of purchasing an option, and it’s calculated based on the underlying asset’s price and values.
• Intrinsic value and extrinsic value: Intrinsic value is the difference between an option contract’s strike price and current price of the underlying asset. Extrinsic value represents other factors outside of those considered in intrinsic value that affect the premium, such as the duration of the option contract.
• In the money (IMT) and Out of the money (OTM): An option is in the money (profitable) or out of the money (unprofitable) depending on the price of the underlying asset and the amount of time remaining until expiration (unprofitable).
• At the money (ATM): the strike price and current price are equal.

Different types of Options

The two basic categories of options to choose from are call options and put options.

Call Options

A call option is a contract that gives the holder the right to buy a digital asset at the strike price on or before the expiration date in return for a premium paid upfront to the seller.

Call options usually become more valuable as the value of the underlying asset increases.

Put Options

A put option is the reverse of a call option. It’s a contract that gives the holder the right to sell a particular asset at the strike price anytime on or before the expiration date in return for a premium paid up front.

Traders often buy put options if they expect the price to fall.

How does Options trading work?

Two tyles of crypto options

• American: Where a buyer can exercise the contract at any time before the expiry date.
• European: Where a buyer can only exercise the contract at the moment of expiry.

The Options trading process

As contracts, options often include two parties: a trader and an exchange. An options seller creates a contract order, with the expiration date and the strike price specified. The seller then lists the contract on a crypto options exchange, where the exchange matches a buyer with the order.

The cost of the premium is determined by the amount of time remaining on a contract before its expiration, the volatility of the underlying asset, the market price of the underlying asset, and interest rates in order to ensure fairness.

In case a trader wants to buy a call option with a strike price that is lower than the current market value of the underlying asset, they will have to pay a significantly higher price for the contract. Which is due to the contract is currently “in the money” and already has intrinsic value. Of course, that doesn’t mean the price will continue to stay above the strike price before the contract expires.

Options trading example

At January: BTC price is $34,000

Simon thinks that at the end of July the price will be considerably higher.

Simon decides to:

• Create 10 European-style call options: Each contract says that Simon has the right to purchase 0.1 BTC at the price of $36,000 when the contract expires at the end of July.
• Strike price: $36,000.
• Premium: 0.002 BTC/contract equal to $68 ⇒ 10 contracts equal to $680.
• Expiry time: July 30.

At July 30 - the expiry date 

In scenario A: BTC price is $40,000 ⇒ Simon executes his call option. ⇒ Profits: $40,000 - $36,000 - $680 (premium)= $3,320

In scenario B: BTC price is $32,500 ⇒ Simon decides not to execute his call option ⇒ The option is now “out of the money”. All in all, Simon makes a loss of $680, the amount he paid for the call premium.

Pros and cons of Options trading

Pros

• Hedging: When the price of the trading asset falls below the strike price, options trading can limit the losses and protect traders from all the severe market fluctuation.
• Leveraging: Options trading helps users to get control over the price of buying assets eliminating putting down the whole assets at risk of violability.
• Limiting risks: Options trading combines specificity with flexibility. If things go wrong, traders do not need to execute the contract except for paying an amount of premium.
• Cost - efficiency: Options trading can be a cost-efficient way to make a speculative bet with less risk while offering the potential for high returns and a more strategic approach to investing.

Cons

• Loss of opportunities: Due to a small change in price movement, traders can lose the chance to buy coins at a beneficial price. Sudden market moves when whales enter the market also pose a high risk to traders.
• The calculated fee mechanism is difficult to understand.
• Sophisticated trading strategies: When compared to the traditional options, crypto trading options are much more complicated.
• Volatility: The value of the options premium is extremely volatile and tends to decrease as the contract’s expiration date approaches.

Differences between Options trading and Futures trading

Both of these financial instruments track underlying assets and allow users to speculate on them, which makes them very comparable. Traders can also take long (call) and short (put) positions with them.

However, their features differ slightly in their modes of operation.

Obligation

Users can acquire an underlying asset at a price other than the current market price via an options contract. It also allows users to "choose" whether or not to buy or sell the underlying asset.

This move, on the other hand, is an obligation under a futures contract, a responsibility that isn't based on the holder's discretion. This implies that if the market fluctuates in the opposite direction in a futures contract, the position will be closed.

An options contract allows you to buy an underlying asset at a price other than the current market price. It also gives you the “option” of buying/selling the underlying asset.

However, in a futures contract, this move is an obligation, a duty that isn't based on the holder's discretion. This means that if the market moves against the direction of a futures contract, the position will be closed at the expiration date. As it’s a type of smart contract, it can execute on its own.

Loss and Risk level

Futures contracts have a higher risk/reward ratio than options contracts.

Unlike options, where the greatest possible loss is restricted to the premium paid for the contract, the loss on a futures contract is determined by how far the price has moved away from your entry.

With futures contracts, the higher the risks, the larger the opportunities/challenges.

Options trading platforms

Binance: This is the biggest derivatives trading platform according to volume on CoinMarketCap for the derivatives sector.

OKX: This is another market in which to trade BTC and ETH options.

Bybit: Ranked #4 on CoinMarketCap for derivatives, Bybit officially added crypto options to its product list in May 2022.

Conclusion

As the crypto market is relatively new, complex instruments are just getting started to gain traction. However, it’s hard to deny that options trading is gradually becoming a useful tool for crypto traders.

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