Options are derivative contracts that ‘entitle’ the purchaser to buy or sell the connected asset at a predetermined price before the contract expires. There are two types of options — call and put. The right to buy is known as a ‘call’ option, whereas the right to sell the underlying asset is called a ‘put’ option.
Unlike futures, wherein contract owners have to buy/sell on a particular date in the future, options are not binding. They are simply opportunities to buy/sell.
In the case of Bitcoin and Ethereum, this means that traders are transacting in buying/selling rights of these two cryptocurrencies. Hence, traders simply gauge the price movement of the underlying crypto, which is, in simpler words, nothing but speculation.
How do crypto Options work?
Crypto options exist in the market because an issuer ‘writes’ (creates) them and lists them on the crypto derivatives exchange. Every options contract comes with a specified expiry date which is the last date for settling the contract.
The price at which the options contract is settled is called the ‘strike price.’ This is the price at which the options contract owner is allowed to buy/sell the underlying cryptocurrency.
The price at which an options contract is bought is called the ‘premium.’
Now, when would you buy a cryptocurrency? Obviously, when it is trading at a price that is lower than it should be, right? This means that you find it to be undervalued, and you expect its price to rise in the future so you can sell higher and make money.
But what if the crypto price fell instead? Wouldn’t it be nice if somebody would still buy the cryptocurrency from you at a higher price? For that, you would require selling rights of the cryptocurrency, and you will buy a put option. Let’s take an example:
Let’s say you bought a Bitcoin put option with a strike price of Rs 500 at a premium of Rs 50. If you exercised your option when the Bitcoin price was Rs 450 and sold it for Rs 500, you would not make any profit because your net sales value would be 500 – 50 = Rs450.
But if you exercised your right after the Bitcoin price dropped to Rs 400, you would then sell it for Rs 500 and still gain Rs 50 overall. (500 – 400 – 50 = Rs 50)
Thus, put options protect you from ‘downside risk.’
Now, on the flip side, when would you sell a cryptocurrency? Of course, when you think that it is trading at a price higher than it should be. This means that you find it to be overvalued and expect it to fall from here.
But what if the price of the cryptocurrency rose instead? You would then want to add more crypto at a lower price and sit on assets that are valued higher than your purchase price. For this, you would need buying rights or a call option. Let’s understand this with an example as well.
Let’s say you bought an Ethereum call option with a strike price of Rs 500 for a premium of Rs 50. If you exercised your buying rights when the Ethereum price was Rs 550, you would not gain anything because you would be buying it at Rs 500 and paying Rs 50 for the call option, amounting to Rs 550.
But if you let the Ethereum price rise to Rs 600 and the exercised your buying right, you would pay Rs 500 + Rs 50 = Rs 550 for Ethereum worth Rs 600. You would thus save Rs 50. Neat right?
Call options, therefore, protect you from ‘upside risk.’
How do crypto options affect the market?
Since options allow traders the right to buy/sell assets at a predetermined price, they shield them from the volatility of the crypto markets. Moreover, the volume of the call or put options in the market signals the direction in which investors expect the markets to move.
More put options indicate that investors expect the markets to fall, whereas more call options indicate that investors expect the market to rally. Now, when the option contracts are near their expiration date, large players try to drive the underlying crypto’s price into a favourable range depending on the option contracts they have purchased. This is done so that the deal can become profitable.
For example, if the Bitcoin price rises, traders will sell call options and push the Bitcoin price back down until the options contracts near their expiration date. Obviously, when the option contracts expire, traders will either want to be profitable or save as much as they can through their rights.