— By Charbel Abi Hanna
You’ve probably heard about options trading but you don’t know how those derivatives products work.
This blog is all about options trading and specifically in crypto.
To this date, Deribit is the largest centralized exchange for trading cryptocurrencies options (Mainly BTC & ETH). Pointing to this is very crucial since our upcoming highlights and illustrations are examples taken from trading options on Deribit.
So, what’s an option contract?
It’s a contract that gives you the choice to buy or sell an asset at a certain price on a specific date.
- BUY or SELL (Not obligated).
- Specific price (Strike).
- Specific date (Expiry date).
- Strike price.
- Specific Date.
Here’s an example:
This option contract lets you buy 2BTC at a 40k$ fixed price on 29/4/2022 and costs you 2k$.
The strike price is 40k$, the premium paid is 2k$ and the expiry date is 29/4/2022
Note: No matter if BTC is sitting at 60k$ on expiry, you can still buy it at 40k$ and make a huge profit by selling afterward at 60k$ (That’s the whole point isn’t it?)
We said that the contract lets you BUY or SELL. From this we conclude that there are two options types “CALLS & PUTS”
CALL: Let you BUY a certain asset at a specific price on a specific date.
PUT: Let you SELL a certain asset at a specific price on a specific date.
For each contract to get executed at expiry, we need a trader in the opposite position.
So for each contract BUYER, we need a contract SELLER.
Here we have 4 distinctive positions:
1- Call Buyer
2- Call Seller
3- Put Buyer
4- Put seller
Long is an option Buying position.
Short is an option Selling position.
PNL & Risk:
Options on Deribit are cash-settled (don’t require massive capital to execute at expiry, unlike physically settled options) and denominated in BTC (premium, profits, and losses are all paid in BTC and not USD).
Referring to the example above:
I- PNL for Call Option Buyer:
The max loss is capped at the premium paid by the Call buyer (in this case 2k$).
The max profit is uncapped (in theory); it depends on BTC price action (in reality).
Breakeven price= Strike price + Premium
1- The 2k$ premium paid by the buyer is going to the seller of the option.
2- Options are a zero-sum game which means that the profit made by the buyer is equal to the loss made by the seller and vice-versa.
3- Breakeven price is where the buyer made up for the premium paid, at a point where he’s neither winning or losing.
II- PNL for Call Option Seller:
Max profit is the premium Collected (2k$).
Max loss is unlimited theoretically if the BTC price kept shooting to infinity.
The breakeven price is the same equation as before, where neither the seller nor the buyer is in profit. (Remember the zero-sum game ?)
III- PNL for Put Option Buyer:
Here we changed the strike price to 45k$.
Max loss is equal to the premium paid (2k$).
Max profit happens only if the BTC price goes to zero and is calculated as the following (Strike price-premium) or the breakeven price which is 43k$ in this case.
1- Don’t get confused, think of the Put buyer as holding a short position on BTC, it gets more profitable when the BTC price tanks. (Max profit if BTC price goes to zero).
2- All of this calculation is made assuming options are priced in USD and not BTC for the sake of simplicity.
IV- PNL for Put Option Seller:
Max profit is premium collected (2k$).
Max loss is the same as maximum profit by the put option buyer(43k$) only if BTC goes to zero, remember it’s a zero-sum game.
Options on Deribit are cash-settled which means it doesn’t require large capital to buy the BTC at a lower price and then sell it back at a higher price in case of a winning call option, you just get your profits by extracting the (expiry price-strike price). The easy way!
Options on Deribit are denominated in BTC which means you pay your premium, collect profit and pay losses all in BTC. All our illustrations above were made in USD for math simplicity since the charts aren’t linear when options are denominated in BTC.
But below we made PNL calculations for BTC denominated options.
But first, let’s touch on the contract multiplier:
The contract multiplier on Deribit is 1x which means buying 1 contract represents 1BTC that you can BUY or SELL at expiry.
Example: You paid 0.1BTC to buy 1 contract (Call option) at a 40k strike, it lets you buy 1BTC at 40k$ at expiry.
BTC denominated PNL:
Max profit for Call buyer in BTC = 1-premium
Max loss for Call seller in BTC = 1-premium
Max profit for Put buyer in BTC = ∞
Max loss for Put seller in BTC = ∞
Note: the premium here is in BTC, it may range between 0.05 and 0.15 in reality, back on that later!!!
Option Moneyness (ITM-ATM-OTM)
ITM refers to the “In The Money” option.
ATM refers to the “At The Money” option, the point where the strike price meets the current BTC price.
OTM refers to “Out of The Money”.
ITM & OTM are different for the four possible positions.
In the charts below:
- Horizontal colored lines refer to what prices the option is considered OTM or ITM.
- ATM is a single point = Strike price.
- Other lines are for the PNL (explained before). You might notice that an option is ITM but is still at a loss, it’s because of extrinsic value. (more on that below)
The premium value:
Premium = Intrinsic value + extrinsic value
Intrinsic value is referred to how much the option is ITM.
Example: A call option with a strike price of 40k$, and the current price right now is 42k$. The intrinsic value is 2k$, since it’s a long call option position, Intrinsic=Price-Strike.
Extrinsic value is the time value of an option. It measures the time between now and the option expiry date.
Example: A call option with a strike price of 40k$ that costs a 2.5k$ premium, expiry date 2 weeks from now and the current BTC price is 42k$. The intrinsic value is 2k$ here.
Extrinsic value = premium-intrinsic value
This is the time value (2weeks) that an option buyer is paying for, the more time until expiry the higher the extrinsic, logically enough because the asset price has much more time to move in the desired direction.
Other factors that affect the extrinsic value of an option are the Implied Volatility or short for IV and the greeks (Delta Δ, Theta θ, Vega ν, Gamma Υ). Luckily for you, those are for the upcoming Options2.0 blog along with the Black-Scholes model and volatility smiles.
European vs. American options:
Similar characteristics but the differences are important. Owners of American-style options may exercise at any time before the option expires. On the other hand, European-style options may exercise only at expiration.
But there’s a difference between exercising and closing an option position before expiry. Exercising (delivering) an option position lets you profit only from the intrinsic value of the option, on the other hand closing an option position by opening an opposite one lets you profit from both extrinsic and intrinsic value, and sure, it requires more capital to open an opposite position. Options on Deribit are European but of course, these can be closed before expiry by opening a position in the opposite direction.
Example: You bought 1 Call option that expires in a month and you’re sitting at a profit now assuming the BTC price pumped, you can short(sell) 1 Call option at the same strike & same expiry to close your position and book the profits. That’s how to close a European option!