An introductory guide to options in the crypto space
Disclosure: The contents of this guide are purely for educational purposes and should not be construed as financial advice. Before investing in options, we strongly advise readers to understand more about options and its risks.
With this guide, readers should have a clearer understanding of what options are, the cryptocurrency options market, the various DeFi option protocols, and how they can participate.
This guide will cover some important basics of options and is targeted towards those with no financial understanding of how option products work.
Options trading is often dominated by large financial institutions and crypto firms in both traditional finance and cryptocurrency markets. Since 2020, options volume traded have skyrocketed 10x as we see more investors and traders move into this space for speculative or hedging purposes. The option markets with the highest liquidity are mainly BTC and ETH, however platforms are also actively developing new option markets for other altcoins.
A significant key difference between crypto option trading as compared to traditional finance option trading is the cost. Since crypto is one of the most (if not the most) volatile asset class on the market, this leads to crypto options priced significantly higher due to the high implied volatility factor.
Currently, key market makers in this space include: QCP Capital, Three Arrows Capital, LedgerPrime and many more.
As shown above, the volume of crypto options traded peaked in April 2021 just before the market crash we saw in mid-May when regulators in China started regulating the industry, restricting institutions from offering any crypto related services and closing down mining farms in the country.
BTC and ETH option interest have steadily bounced back from the crash we saw in May 2021. This phenomenon signals a strong demand for option products in the crypto market.
Currently, centralised platforms offering crypto options trading are dominated by a few firms, namely Deribit, OKEx, CME, LedgerX and bit.com with Deribit taking the lead with the largest share of the options market as shown above.
With the recent DeFi explosion. DeFi platforms have also started their own option trading offerings in the market. QCP Capital, for example, now trades more than US$1 billion in crypto options on DeFi platforms per month, and the firm also recently traded US$1 million in AAVE and Luna options on Ribbon Finance and ThetaNuts Finance, respectively.
From the Nansen Dashboard, we also observed that the quantity of transactions for Ribbon Finance and Stake Dao has fluctuated over time. The TVL on these two platforms, on the other hand, have been continuously increasing over time. While both platforms have been slowly introducing new option vaults that could attract new TVL, it could also imply that such option trading platforms are successful in attracting long term user usage.
Option trading is generally considered to be more complex than spot trading due to the 3-dimensional nature of the product. - Factors include: time value of option, asset price direction, asset volatility, sensitivity to interest rates.
There are 2 styles of options available:
There are 2 types of options available. You can both buy and sell options.
When you purchase an option, the price you pay to the seller of the option is known as “option premium”. Likewise, when you sell an option, you will earn the option premium from the buyer. The option premium is determined by several factors such as implied volatility. Most DeFi platforms that offer option trading such as Stake Dao offer automated sell-put strategies.
Option strike price is the price at which an underlying asset can be bought / sold.
Based on the option payoff diagram, we can understand the following points.
You buy a BTC call option with a strike price of US$50,000 and to purchase this call option, you paid an option premium of US$500. A few days later, the spot price of BTC rose up to US$55,000.
Profit: $55,000 - $50,000 - $500 = $4,500
You buy a BTC put option with a strike price of US$50,000 and to purchase this put option, you paid an option premium of US$500. A few days later, the spot price of BTC dropped to US$45,000.
Profit: $50,000 - $45,000 - $500 = $4,500
You sold a BTC call option with a strike price of US$50,000 and when you sold the option you earned an option premium of US$500. A few days later, the spot price of BTC rose up to US$55,000.
Profit: $50,000 - $55,000 + $500 = - $4,500
You sold a BTC put option with a strike price of US$50,000 and when you sold the option you earned an option premium of US$500. A few days later, the spot price of BTC dropped up to US$45,000.
Profit: $45,000 - $50,000 + $500 = - $4,500
The Black Scholes Model was developed in 1973 and is widely used today to price European style options.
If you are curious, this is what the Black Scholes Model formula looks like.
C0 = S0N(d1) - Xe-rTN(d2)
d1 = [ln(S0/X) + (r + σ2/2)T]/ σ √T
d2 = d1 - σ √T
Where C0 = option price
Option greek measures the sensitivities of option value based on a specific factor, holding the other factors constant. In total there are 5 option greeks, however Rho is not really used in crypto.
Delta shows how much the option will appreciate in value for each dollar increase in the price of the underlying asset.
Gamma is the ratio of the change of delta to the change in the underlying asset price. It answers the question of “how much does the delta change due to factors such as interest rate changes, volatility, etc).
Personally, I like to think of gamma this way:
When gamma is high, delta moves quickly like an ostrich on steroids, any slight movement in the price of the underlying asset will change delta significantly.
When gamma is low, delta moves like a tortoise who just had a few shots. You will need significant price changes to see any changes in delta.
Vega measures the sensitivity of the price of an option to changes in volatility. Options love volatility!
Theta is the ratio of the change in option value to the decrease in the time-to-maturity. This is one of the most important concepts for a beginner to understand as it explains the effect of time on option premium.
In this section, we will talk about some common option strategies that are widely used by traders.
As we mentioned earlier in this guide, should the asset spot price rise above the strike, longing a call allows you to capture the difference between the higher spot price and the lower strike price. Likewise shorting a put option allows you to earn the option premium which can be significant if volatility is high.
Should the asset spot price go below the strike, longing a put allows you to capture the difference between the lower spot price and the higher strike price. Similarly, shorting a call option lets you earn the option premium.
When to use it: Neutral to slightly bullish outlook
Method: Buy underlying asset + Sell a call option on the underlying
If you are OK with giving up some upside in return for option premiums then this strategy is useful for you.
If the underlying price rises significantly, your potential losses are capped as shown in the payoff diagram. The maximum profit potential is the sum of the call premium and the difference between the strike price and the underlying spot price.
Usually traders sell ATM or OTM options that have a higher chance of expiring worthless and you get to keep the option premium you received without further obligations. This strategy is most commonly done when volatility is high and expensive. Most DeFi platforms that offer option trading such as Ribbon Finance offer covered call strategies.
When to use it: Neutral to slightly bearish outlook
Method: Short underlying asset + Sell a put option on the underlying
Works essentially the same way as covered call, except that we are shorting the underlying asset and selling a put option. However if the underlying asset skyrockets, you will be exposed to unlimited risks. Also most commonly done when volatility is high and expensive.
When to use it: Slightly bullish (Expects a moderate rise in asset price)
Method: Long call options at a specific strike while also simultaneously shorting call options at a higher strike. Both call options should have the same expiration date and underlying asset.
Bull spread has both a limited max gain and a limited max loss and is usually executed with call options but may also be done with put options. If you want to use put options, short put options with a higher strike and long another put with a lower strike.
For example if you want to speculate on BTC price increase with limited downside, then a bull call spread could be used.
When to use it: Slightly bearish (Expects a moderate decline in asset price)
Method: Long put options at a specific strike while also simultaneously shorting put options at a lower strike. Both put options should have the same expiration date and underlying asset.
Very similar to the earlier bull call spread strategy. This also has limited upside and downside. Bear spreads are often done with put options but can also be done with call options nonetheless. If you want to use call options, simply short one call with a lower strike and long another call with a higher strike.
For example if you want to speculate on BTC price decrease with limited downside, then a bear put spread could be used.
When to use it: Significant price movements but unsure of price direction
Method: Long a call and put option on the same underlying asset with the same strike and expiration date.
Technically this strategy allows traders to have unlimited upside and limited downside. Whereby the maximum loss is limited to the total cost of both option contracts combined. Traders like to use this strategy when they are unsure which direction the market will move but also want to bet on market volatility.
If you are a DeFi liquidity provider, you could technically use this strategy to hedge against impermanent losses as well, since price direction is not a key concern here.
For crypto markets, it's extremely risky to use a short straddle strategy due to the extreme volatility. Can you imagine if you short market volatility? The premiums might be juicy but if you are not an experienced options trader... don’t do it pal, its probably a suicide move.
When to use it: Large price movements but unsure of price direction
Method: Long an OTM call and put option simultaneously on the same underlying asset and with the same expiration date.
This strategy is pretty similar to straddle, the difference lies in the different strike price of both options. Similarly, losses are limited to the total cost of both options.
Traders sometimes use strangles instead of straddles since they are almost always less expensive due to the OTM options.
*This list is not exhaustive. There are plenty of other option platforms out there.
