Crypto markets are maturing. The introduction of perpetual future contracts, option trading, leveraged tokens, volatility contracts and many such instruments are most likely what we need for institutional hedge funds/prop desks to take the crypto markets seriously.
Options are one such financial instrument that could see stock market option traders coming into Bitcoin trading.
More money flowing into Bitcoin is a good thing, right?
Options have been a part of the traditional stock markets for quite some time. Most retail traders like you & me usually think of them as very complicated instruments that need a financial degree or a genius level IQ to make money trading them. This couldn’t be further from the truth.
When you read about how options work, it all starts making sense to you. But be warned, options are not a get rich quick tool (unlike how the gurus claim). You will go full tilt if you do not understand the risks involved with trading options.
Introduction to Options
There are primarily two types of options.
- Call Options
- Put Options
I am not quoting the textbook definition here, as it tends to complicate things. In simple terms:
You buy a Call Option when you think the price of an asset will go up.
You buy a Put Option when you think the price of an asset will go down.
Here’s an example that tries to explain how options function.
Suppose Naimish (the founder of this site) decides he wants to buy a home in Mumbai and is looking for a posh duplex in SoBo (South Bombay). He finds a project that is under development and asks the builder for a quote. The builder quotes him Rs. 15 Crores (150 Million) for a 4BHK duplex. Naimish is quite happy with that price and books the flat with an advance payment of Rs. 15 Lakhs. The project is expected to complete after 5 years.
What Naimish essentially did was to buy the option of buying a flat for Rs. 15 Crores, at the end of 5 years.
At the end of 5 years, Naimish has to pay the remaining Rs. 14.85 Crores, if he wants to claim the flat.
Now, five years have passed and there are multiple scenarios here but for simplicity, let’s just consider two primary scenarios, one mentioned above, another is a complete failure of the project.
Scenario 1 – The price of the Flat is now Rs. 50 Crores
The market value of the property after five years has appreciated. It is now Rs. 50 Crores. Naimish wants to sell the flat and move out of Mumbai. So he decides to find a buyer.
Sachin is looking to move from Hyderabad to Mumbai and he really likes the posh 4BHK duplex. The market price is Rs. 50 Crores but since Naimish is a good friend of Sachin, he decides to give him a cheeky 2% discount.
Sachin buys the flat from Naimish for Rs. 49 Crores.
Here, Naimish’s P&L is
P&L = Rs. 49 Crores – Rs. 15 Crores = Rs. 34 Crores
P&L% from initial investment = Rs. 34 Crores / Rs. 15 Lakhs = 22666 %
Talk about phenomenal gains!
Scenario 2 – The Project Fails
The project has failed to materialise and the builder has run away. Naimish is now sitting at a loss of Rs. 15 Lakhs.
P&L = – Rs. 15 Lakhs
This is a general example of buying a call option. When you buy a call option, the downside is limited but the upside is unlimited.
Basically an Option contract is the option but not a compulsion to buy an asset at a later point of time at a predetermined price.
We buy a Call Option when we think the price of an asset will go up.
We buy a Put Option when we think the price of an asset will go down.
The opposite stands true for option selling.
We sell a call option if we think the price of an asset will go down or stay stable.
We sell a put option if we think the price of an asset will go up or stay stable.
Option selling is also known as writing options.
Buying options have limited loss potential and theoretically unlimited upside potential, as mentioned in the above example.
Selling options have limited profit potential and theoretically unlimited downside potential.
It is a zero-sum game, if someone is making an obscene amount of money, someone on the other side is losing the same amount. (excluding fees and taxes ofcourse)
If you are Bullish, you can
- Buy a call option
- Sell a put option
If you are Bearish, you can
- Buy a put option
- Sell a call option
Fig. (a) represents P&L when you buy a call option. The losses are limited if the price stays lower than or at the strike price. The profits grow higher when the price of the underlying goes up.
Fig. (b) represents P&L when you buy a put option. The losses are limited if the price stays higher than or at the strike price. The profits grow higher when the price of the underlying goes down.
Fig. (c) represents P&L when you sell/write a call option. The profits are limited if the price stays lower than or at the strike price. The losses grow higher when the price of the underlying goes up.
Fig. (d) represents P&L when you sell/write a put option. The profits are limited if the price stays higher than or at the strike price. The losses grow higher when the price of the underlying goes down.
These are oversimplified P&L examples. There is a lot of depth involved in options which is too much detail for the purpose of this post. You can read this in- depth and understand the theory behind options in this article by Zerodha.
There are a ton of different strategies you can use to trade options. For simplicity, we will stick to one strategy which is called a straddle. MOVE Contracts are ready made straddles. Few exchanges offer MOVE contracts, you can learn more about them here.
Readymade Straddles / MOVE Contracts
When you buy both call & put options, you get a long straddle.To visualise, combine fig. (a) + fig. (b) and you will get fig. (e)
When you sell both call & put options, you get a short straddle.To visualise, combine fig. (c) + fig. (d) and you will get fig. (f)
Now, you can go ahead and buy both naked call & put options if you want to create a straddle.
Although, why would you go through all that trouble when you have MOVE contracts that are essentially a readymade straddle.
Fig. (a) is your P&L graph when you long MOVE contracts which is essentially a long straddle.
Fig. (b) is your P&L graph when you short MOVE contracts which is essentially a short straddle.
Exchanges to Trade Bitcoin Options
There are only a handful exchanges that offer Options and MOVE Contracts.
The specifics of each contract changes according to the exchange you want to trade them on and there could be several subtle differences in the same offering between exchanges.
These help documents do a great job of explaining them:
In part two of this post, we will discuss MOVE contracts – ready made Straddle. You can check it our by clicking the link below
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