When it comes to aspects of the market that are misunderstood - or not understood at all - the category of derivatives, and more specifically options, immediately comes to mind. To address this lack of knowledge and help you get a better grip on the markets, that’s exactly what we’ll cover in this week’s How-to Crypto, which will be all about options: from the theory on what they are and how they work all the way to some very practical info on how options PnL works.
Options are a type of derivatives, a class of financial instruments that consists of options and futures, while the term “derivative” comes from the fact that they derive their value from something else, namely the underlying asset (for example, Bitcoin options and futures contracts derive their value from the price of Bitcoin). Both options and futures are different types of contracts, which represent agreements to buy or sell the underlying asset on a future date and at a specific price (the strike price), but while a futures contract gives its holder the right and the obligation to buy or sell the asset at the expiration date of the contract, an option contract only gives its holder the right to do so, and this right may or may not be exercised. Based on what side of the trade they represent - whether it’s the right to buy or sell the asset - options are divided into call (buy) and put (sell) options. The price of the option itself (not the strike price, but the price you need to pay to buy the option contract) is called the premium.
This might sound a bit complicated, but you can see that it’s fairly simple if we take a concrete example: let’s say that Bitcoin is currently trading at $63,000 and you buy one call option contract for BTC with an expiry date on December 31 (so a bit more than two months out), a strike price of $64,000, and a premium of $9,500.
When you do that, you immediately pay the $9,500 premium, and you have the right to buy 1 BTC for $64,000 on December 31. If the price of Bitcoin is under $64,000 on the expiration date, you will choose not to exercise the option, of course, and it will expire worthless, meaning that your total loss would be $9,500 (the premium you paid at the beginning). But that’s also the neat thing with options: even if Bitcoin hypothetically dropped to $100, your loss would still be only $9,500, since you can never lose more than the premium that you pay at the beginning.
In the example above, your break-even point would be at $73,500: if Bitcoin ends up at this price on the expiration date, you’ll make $9,500, but this is also the premium you paid at the beginning, so that your total PnL (profits and losses) would be $0. Now, for every dollar above $73,500, you will have a dollar of profit: for example, if the price at the expiration date is $83,500, your profit will be $10,000. On the other hand, if you had just bought spot Bitcoin with $9,500 at the beginning instead of the option, your profit at a price of $83,500 would only be around $3,000. As you probably can tell by this difference between the profit in these two scenarios, options enable a form of leverage, i.e. being exposed to the price of an asset to a greater extent than you would by just holding it on spot.
In that sense, options are similar to futures, but the main difference is in the potential losses incurred: whereas having a too large negative PnL on futures can cause your account to be liquidated as the price moves against you, the maximum negative PnL with options is paid up-front. In other words: when you buy an option contract, whether it’s a call (long) or a put (short) you can never lose more than the price of the contract - i.e. the premium - that you pay at the beginning, making it somewhat easier to manage risk than with futures.
Another interesting thing with options is that they can be used in more complex ways to create new strategies: for example, you can buy both a call and a put for a specific asset, in which case you are betting on volatility. In other words, if you think that Bitcoin is likely to move in a very volatile way - but you’re not sure if that will be up or down - you can use an options strategy to profit as long as Bitcoin moves sharply, regardless of the direction in which it moves. On the other hand, you can also bet on decreased volatility, i.e. on the price of an asset staying similar to the current price - or you can create any combination of strategies that you want, adjusting your exposure to many different possible scenarios.
These more complex strategies will need to be covered in a separate article, so for now, the key point is that you keep in mind how options work in the basic sense, namely what calls and puts are, how you can profit from them and how the PnL of options works. The best way to make sure you’ve got that down is to try to briefly state the basic mechanisms in a few sentences and refer back to this article if you find yourself stuck - once you can do that, you can be sure that you’ve mastered the essentials and you’ll be ready to learn about more advanced topics which we’ll cover in later articles.