Crypto Digital Options: A Guide To How They Work

The last few years have seen the rise and rise of crypto currencies. The rise in question isn’t simply referring to the value of a crypto currency like Bitcoin, which was worth around $10 in 20011 and is currently valued (at time of writing) at $11,334, it’s also a reflection of the degree to which crypto currencies have become a part of the financial landscape. For the majority of people this means that it’s become easier than ever to buy or sell goods and services using crypto currencies, as the idea that they are some kind of techno-fad that will soon run its course has been shown to be demonstrably false. For traders and investors, on the other hand, the emergence of crypto currencies as a viable alternative to what might be termed ‘heritage’ currencies has opened up a new range of possibilities.

Crypto Digital Options

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Crypto currency options are just one of those possibilities, and they open up the chance to profit from knowledge or insight into the shifting value of crypto currencies, without having to take the risk of actually buying and selling the currencies themselves.

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The key to the appeal of crypto currency options is the fact that the crypto market can be extremely volatile, offering the chance to cash in on large shifts, but also throwing up the risk of losing out in a major way if those shifts run in the ‘wrong’ direction.

How options work

Options have been around as a trading choice for many years, having originally emerged as a device via which farmers could secure the price of their crops when presenting them to the market. A trader can purchase two types of option, labelled ‘call’ or ‘put’. The chief point to bear in mind when dealing with options is that the trader is buying the right to buy or sell an asset by an agreed date. If you buy a ‘call’ option you’re betting on the value of the asset in question increasing and being above a specific point when the option expires. If you buy a ‘put’ option you’re placing the opposite bet - that the value of the asset will fall below a certain level. This level, known as the Strike price.

A cryptocurrency example

You may feel that the price of bitcoin is going to rise from its current level of $11,334 to hit $15,000 in the next two months. If you want to profit on this shift, then you have two options:

  • You could buy bitcoin and sit on it for two months before selling it if and when it hits the price you were hoping for.
  • You could pay a much smaller fee for bitcoin options, opting for a strike price of $15,000 and an expiry date of two months.

The fact that each of the options only comes with a relatively small fee attached – particularly when compared to actually purchasing the cryptocurrency itself – means that you can leverage the amount of money you have available to invest by purchasing a number of options. If your hunch is right and the options end up ‘in the money’ – which is to say that the value of bitcoin hits the Strike price or higher by the expiry date – then you earn a lucrative return on your investment. Of course, and this is important to bear in mind given the volatility of the crypto markets, if the value of the cryptocurrency option you purchase drops below the Strike price then you lose your investment.

Hedging

An alternative use of crypto options is as a hedge against losses in the rest of a portfolio. You could do this by purchasing a put option on crypto with a strike price which is 20% below the current value and an expiry date of four months’ time. If the value of the currency does indeed collapse by 20% over the period you’ve specified, then the impact this might have on the rest of your crypto portfolio will be mitigated to a degree by the put options you purchased.

Expiry Date

It should be noted that an option can be traded in at any time before the expiry date as long as it has hit or exceeded the Strike price. The amount of profit you make will be determined by how much higher than the strike price the value of the crypto has risen. In the example given above, with a strike price of $15,000, you may be tempted to ‘cash in’ once the value hits $16,000. On the other hand, with another month to go before the expiry date, you might choose to bet on a further rise in value. The excitement – and risk – of trading crypto options lies in the speed at which huge shifts in value can take place. Hold on for too long and the value could suddenly drop, instantly rendering your options worthless unless things change again before the expiry date.

In order to trade bitcoin options a trader needs to sign up to an options trading platform such as Deribit Ledgerx and Quedex. Once you’ve registered on a platform, you’re free to choose from a range of options, selecting those which match your investment style and the amount you have to play with (and can afford to lose) the most closely.

To summarise, the key phrases to bear in mind when considering trading crypto options are as follows:

  • In the money – the phrase ‘in the money’ has a counterpart, ‘out of the money’. In both cases it refers to the price of the cryptocurrency in question when compared to the Strike price initially selected. If the current value of the asset is higher than the Strike price, then a put option is profitable, or ‘in the money’, and can be traded in to cash in on that profit. If, on the other hand, the value is lower than the Strike price then the option is ‘out of the money’ and, if the expiry date passes, becomes worthless.
  • Strike price – the Strike price is the level at which the option becomes ‘in the money’ and you have a choice to make as to whether to cash in.
  • Expiration – this is the final date on which the option can be traded. Following that date, no matter what happens before, the option no longer has any value and the investment is lost.

Trading in crypto options offers an affordable means of profiting from the volatility of the crypto markets without having to make the investment required to acquire large amounts of the cryptocurrencies themselves. Whilst it’s possible to take advantage of the volatility of the market it always needs to be remembered that the same sudden shifts can render trades worthless, and that close vigilance is needed at all times.



About the Author

Ankur Shah
Ankur Shah is the founder of the Value Investing India Report, a leading independent, value oriented journal of the Indian financial markets. Ankur has more than eight years of equity research experience covering emerging markets, with a focus on India and South East Asia. He has worked as both a buy-side investment analyst for a global long/short equity hedge fund and a sell-side analyst for an emerging markets investment bank. Ankur is a graduate of Harvard Business School. You can learn more about his latest views on global markets at the Value Investing India Report. -- He can be emailed at AnkurShah47@gmail.com