In this Guide, we will cover Bitcoin options trading, options trading platforms and how to trade bitcoin options on deribit.
An options contract is an agreement between the seller and the buyer, which gives the buyer the right to exercise the conditions of the contract on a specified date, at a specified rate. Bitcoin options trading, therefore, is the process of entering into an agreement with buyers or sellers, using an options contract.
An options contract is similar to a futures contract, except that it is a right, not an obligation. An option is a contract that is usually a derivative of a futures or forwards. Hence, the losses in case be limited if the buyer of an option chooses not to exercise his rights. Nevertheless, the seller of an option stands at an unlimited risk position, as he is obliged to the will of the buyer.
Types and Styles of Options
Options contracts are usually of two types:
- Call Option: It is an option to buy the underlying asset at a predetermined price on or before a specified date.
- Put Option: It is an option to sell the underlying asset at a predetermined price on or before a specified date.
Then, there are usually two styles of options:
- An American Style Option: Can be exercised at any date before expiry
- A European Style Option: Can be exercised only at expiry
Currently, most of the options available in the market are European Style only. It includes exchanges like CME, Deribit, Okex and so on. Hence, the option to exercise these contracts are available only at expiry.
Bitcoin Options Trading
Bitcoin [BTC] options are currently traded on CME, Deribit, LedgerX, IQ Option, Quedex, Bakkt and, Okex. Among these, CME, Bakkt, and others are regulated platforms in the US, with the CME group being the largest futures exchange in the world.
Moreover, while most exchanges offer buying of options only, Okex has enabled selling options as well. However, selling an option is a lot closer to futures in terms of risk. The sellers stand to make profit from the premiums paid by the buyers of unexercised options.
Bitcoin options are usually the only derivatives contract offered on exchange. Nevertheless, lately the regulators including the CFTC have expressed positive sentiments around Ethereum being traded as a commodity.
Ethereum futures contracts are traded across many exchanges including Binance, Huobi, Okex, and BitMEX as well. The options contracts on these futures are not widely available at the moment.
Deribit exchange is one of few exchanges which offers options on Ethereum. The ETH-USD on Deribit is composed of price discovery from Bitfinex, Gemini, Bitstamp, GDAX, Kraken and Itbit.
Moreover, Binance and some of the other derivatives exchange offer futures contracts on other crypto like XRP, Litecoin [LTC], Bitcoin Cash [BCH] and so on. In the future, if enough distribution is achieved and these contracts are available across more exchanges, we’re likely to see options being written on these cryptocurrencies as well.
How to Trade Bitcoin Options on Deribit?
To understand how to trade options, one must understand that it is simply a trade deal decided for the future. The buyers and sellers of the contract make profit/loss on the difference in the strike price (the contract price) and the price at expiration.
Moreover, this is a lot similar to futures, and might fail to choose between the two. Hence, it is essential to understand how margin and premium works.
Understanding Margin and Premium Rate
The writer or seller is an entity that sells these calls and put options. The seller of options has unlimited liability, in case the buyer exercises his options. Hence, the writer pays a margin to the broker or the clearing house in this case.
The buyer of the option obtains a right rather than an obligation on his call and put option. To opt for this option, the buyer needs to pay a premium to the writer.
For example, look at the order book of Deribit Exchange below, it gives the rate of buying Call and Put options (bid and ask column).
Let’s say the option to buy a call (of 3 BTC) at a strike price of $4,000 (therefore, $12000 in total) is around $2,200. Hence, in case the price rises to $6000 at expiry, the buyer of the call option on 25th expiry will buy cheaper bitcoins (about $6000, $2000X3 cheaper than the expiration price) for a premium of around $2,200.Hence, he ends up making a profit of $4,800.
How to Make Profit on Bitcoin Options?
To understand an options contract one must understand the premium and margins. The buyer of an option pays a premium for either selling or buying a certain amount of Bitcoin at a certain time, on a specified date.
- The buyer of a call or put option pays only the premium
- But, the seller of the put or call option pays the margin, which needs to be covered according to the strike price and market price. However, in case there is little difference between the strike price and expiration date price, the seller makes profit on the premiums.
Note, the buyer only makes a profit if the odds turn in his favor above the premium paid for the option.
Hence, the rate of premium on specific strike price is an important metric which can also help in understanding the market sentiments.
For e.g. let’s’ say the premium for a Bitcoin call option is high, then it implies the traders are bullish. On the other hand, if the premium for a Bitcoin put option at a particular strike price is high, it means that traders are heavily betting on the price falling below it on expiration.
Risk Management: Who are Likely to Buy and Exercise Bitcoin Options?
Futures and options contracts were originally formed to protect or hedge the losses of companies depending on the asset they trade or produce. Nevertheless, in today’s market, these are used as speculative instruments which often come with high leverage as well.
Leverage of 10x-100x implies that some of these derivatives contracts lets a trader bet on 100 Bitcoin using only 1 BTC. Nonetheless, the risks associated with the ‘leveraged’ contracts are equally high. It is basically borrowing money from liquidity providers to speculate on assets.
Difference between positions of Miners and Speculators in Bitcoin options trading
Generally, a miner with an equivalent amount of assets, let’s say 100 BTC by the end of September is likely to lock in his Bitcoins at a fixed ceiling price to avoid losses from a downfall.
Hence, the miner can sell futures contracts at the present rate. Hence, if the price drops below the present rate, he earns on the difference between the expiration price. This makes up for the loss he is incurring on the 100 Bitcoins.
An options market ups the ante for the miners, the buyer of a put option at the higher strike price will have an option to earn the profits in case of a drop. However, if the price rises above the strike price, he will choose not to exercise his options and benefit from the 100 new Bitcoins produced. Hence, by using options, the miners are protected against losses and also have an opportunity to earn from the moves, by exercising the option at will.
Digital Asset Management firms are also likely to buy futures and options to hedge their assets and increase liquidity in their firms.
Traders are more likely to buy futures contracts because the funding rate is substantially lower than the premium on options.
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