To better understand how options work, here are some simple examples of how to use them either to appreciate or protect your crypto assets.
The long call option strategy is the most basic trading strategy in this field, whereby a user buys call options with the belief that the price of the underlying asset will rise significantly beyond the strike price before the option expiration date.
Sam is an ETH hodler and he is bullish due to the growing DeFi ecosystem on Ethereum. He is holding 1 ETH already. To maximize his gains if the price goes up in the near future, Sam buys 1 ETH call with the strike price of $700 and the expiry of 15 days. The premium is $70 for each contract.
If the price grows by 20% to $840 in two weeks, Sam will get $140 ($840-$700) by exercising the call, and the return is 100% (($140-$70)/$70). The call gives Sam a 5x leverage in return.
If the price drops by 20% to $560 in two weeks, Sam will not exercise the call option and $70 will be all he can lose.
For holding one ETH, Sam may lose only $140 in case of a price collapse.
If Sam is extremely bullish, he could even decide to deposit ETH on MakerDAO, Compound or Aave, and borrow stable coins to buy call options. This would give him further leverages and higher risks.
A protective put position is created by buying (or owning) an asset and buying put options with a strike price equal or close to the current price of the asset.
Henry is holding ETH and is satisfied with the recent bull run to over $750. While he is concerned that the market may be headed for a correction, he does not want to give up potential profits if the market continues to rise.
To make the most out of this situation, Henry buys put options as insurance, with a strike price of $740. This means that even if the market drops, he still has the right to sell at $740. If the ETH price continues to rise, he can always choose not to excise the puts and ride the bull run.
In this example, Henry is buying puts working as insurance, with which he can sleep tight at night with protections and still enjoy the possible gains.
A covered call is created by owning an asset and selling an equivalent amount of call options. To execute this strategy, a trader holds a long position in an asset and writes (sells) call options on that same asset to generate an income stream.
Lucy is holding ETH with a price of $750. She expects that the market will stay flat for a while and wants to possibly lower her cost in the flat market. Therefore, she decides to sell ETH calls with the strike price of $760 and earn the premiums of $50 immediately.
If the price gets higher than $760, she will sell when the option buyers exercise the calls. If the price stays lower than $760 till expiration, she will still get premiums and lower the cost of holding one ETH by $50.
In this example, Lucy employs a covered call strategy as she intends to hold the underlying asset for a long time but does not expect an appreciation in price in the short term, and she is satisfied with selling the assets at a predetermined price.
If one writes/sells a put option, that investor is obligated to purchase the underlying assets if the option buyer exercises the option.
Ted is bullish on ETH, and he wants to increase his investment if the market makes any corrections. For instance, assuming the price is $800, he would like to increase his investment if the price returns to $750.
Ted could place orders on exchanges — but it would be even better if he sold a put option with a strike price of $750, thus pocketing an immediate $30 in premium. While if the market actually drops to the target price of $750, he could immediately make a purchase when the option holder exercises.
Selling puts can be a useful strategy for buying the dips at the target price while generating immediate cash flows.
Miners normally have fixed costs to pay and dislike volatility, especially when the prices collapse. Options can be an effective tool to minimize these risks.
John is an ETH miner and expects to mine 100 ETH per month. However, he needs to pay $30,000 for electricity on the fourth of every month. He is concerned that ETH may abruptly drop in value — like it did in March 2020 — which would certainly undermine his profit. Each month, he buys 50 units of ETH put options with a strike price of $600 and an expiry date of one month, to make sure that the monthly electricity bill is covered.
It may cost him $2,000 in total, but the put option works as insurance, and he will still benefit from the ETH upward potential.
A straddle is a strategy that involves holding an equal number of puts and calls with the same strike price and expiration dates. It is a useful strategy to profit from increasing volatility, regardless of the market direction.
Let us imagine that ETH moved up dramatically to $1,000 over the past few days. Alex is not sure ETH is going to go upwards or downwards in the near future. But, he expects that any movement will be a big one and wants to exploit this higher volatility. He can choose to long a straddle by buying a call and a put together with the strike price of $1,000. If the market moves up, the call is there; if the market moves down, the put is there.
It may cost him $120, but as long as ETH either rises above $1,120 or falls below $880, Alex will still end up in profit. The premium of $120 is all he may lose from the strategy.
In other words, Alex may successfully earn profits on a volatile market even if he is not sure where the price is heading.
From the examples above, we may notice that options are very different from both the spot trading market and better-known derivatives like futures or perpetuals. Interesting strategies may be deployed with a flexible combination of options and spot, covering a range of scenarios. Risk-return profiles would vary accordingly.
Decentralized options are newcomers in the DeFi space. They were born in 2020, but have great potential and are developing fast. They are non-custodial, open-source, permissionless and interoperable.
Furthermore, the creation of pooled liquidity has solved the problems on-chain where order books could be costly to apply. Please refer to this article for more in-depth reading about decentralized options protocols.
Disclaimer
While FinNexus hopes traders will find this article useful, please be aware that options are a multi-faceted and potentially risky product. Before implementing any financial decision please always do your own research first.