Cryptocurrencies are volatile assets that can experience large price swings in a short period of time. This makes them attractive for traders who want to profit from the market fluctuations, but also exposes them to high risks of losing money. One way to reduce the risk of trading cryptocurrencies is to use options, which are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price and time.
Options can be used for various purposes, such as hedging, speculation, income generation, or portfolio diversification. In this blog post, we will explain how options work and how they can be used for risk management in crypto trading.
What are options and how do they work?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (called the strike price) and time (called the expiration date). The buyer pays a fee (called the premium) to the seller (also called the writer) of the option to acquire this right. The seller receives the premium and agrees to fulfill the contract if the buyer exercises the option.
There are two types of options: call and put. A call option gives the buyer the right to buy the underlying asset at the strike price, while a put option gives the buyer the right to sell the underlying asset at the strike price. The buyer can exercise the option at any time before or on the expiration date, depending on whether the option is American or European style. Alternatively, the buyer can sell the option to another trader before it expires.
The value of an option depends on several factors, such as the price of the underlying asset, the strike price, the time to expiration, the volatility of the asset, and the interest rate. Generally, an option is more valuable when it is in-the-money (ITM), meaning that it would be profitable to exercise it. For example, a call option is ITM when the price of the underlying asset is higher than the strike price, while a put option is ITM when the price of the underlying asset is lower than the strike price. An option is out-of-the-money (OTM) when it would be unprofitable to exercise it, and at-the-money (ATM) when it is neither ITM nor OTM.
How to use options for risk management in crypto trading?
Options can be used for risk management in crypto trading in various ways, depending on the trader’s goals and risk appetite. Here are some examples of how options can be used for hedging, speculation, income generation, or portfolio diversification.
Hedging: Hedging is a strategy that aims to reduce or eliminate the risk of an existing position or portfolio by taking an opposite position in another asset or instrument. For example, a trader who owns some bitcoins and expects them to rise in value can buy a put option on bitcoin to hedge against a possible drop in price. If bitcoin falls below the strike price of the put option, the trader can exercise it and sell bitcoin at a higher price than the market price, thus offsetting some or all of their losses. On the other hand, if bitcoin rises above the strike price of
the put option, the trader can let it expire worthless and keep their bitcoins and their gains.
Speculation: Speculation is a strategy that aims to profit from market movements by taking a position based on a prediction or expectation of future price changes. For example, a trader who expects bitcoin to rise in value can buy a call option on bitcoin to speculate on its upside potential. If bitcoin rises above the strike price of the call option, the trader can exercise it and buy bitcoin at a lower price than the market price, thus making a profit. On the other hand, if bitcoin falls below the strike price of the call option, the trader can let it expire worthless and lose only their premium.
Income generation: Income generation is a strategy that aims to earn a steady income from selling options and collecting premiums. For example, a trader who owns some bitcoins and expects them to trade in a narrow range can sell a call option and a put option on bitcoin with different strike prices but the same expiration date. This is called a strangle strategy. The trader receives premiums from both options and hopes that bitcoin stays within
the range defined by the strike prices until the expiration date. If this happens, the options expire worthless and the trader keeps their premiums and their bitcoins. However, if bitcoin moves outside the range, the trader may have to buy or sell bitcoin at an unfavorable price, thus losing money.
Portfolio diversification: Portfolio diversification is a strategy that aims to reduce the overall risk of a portfolio by investing in different assets or instruments that have low or negative correlation with each other.
For example, a trader who has a portfolio of stocks and bonds can buy a call option on bitcoin to diversify their portfolio and gain exposure to the crypto market. If bitcoin rises in value, the trader can benefit from the option and increase their portfolio returns. If bitcoin falls in value, the trader can limit their losses to the premium and still enjoy the returns from their other assets.