Options are a crucial financial instrument for professional traders, used both in traditional markets and in the crypto market. They allow traders to diversify trading strategies, effectively manage risks, and broaden their range of investment tools. Options provide the opportunity to implement profitable strategies under various market conditions and deepen understanding of market dynamics. Studying options can significantly enhance overall trading effectiveness.

What Are Options?

What Are Options?

An option, also known as an option contract, is an agreement with predefined terms that grants participants the right to buy or sell a specific asset at a fixed price before a specified date.

The concept of options derives from the Latin word “optio,” meaning choice or discretion. An option is a derivative financial instrument.

The buyer of an option is known as the holder, while the seller of the option is called the writer. The contract is initiated by the option seller, who takes on the obligation to buy or sell the underlying asset at the agreed-upon price.

Types and Varieties of Options

Types and Varieties of Options

Unlike straightforward buying and selling operations, options offer traders various opportunities to diversify their trading strategies by choosing from different types and varieties of options, with different strike prices and expiration dates. This enables more effective management of positions based on market expectations and strategies.

Types of options include:

  • Put options: these give the buyer the right to sell the underlying asset at a specified price.
  • Call options: these grant the buyer the right to purchase the underlying asset at a pre-agreed price.
  • Double options: these provide the owner the right to either buy or sell a contract based on the underlying price movement, combining two independent option contracts with different conditions and granting the investor two separate rights to operations with the underlying asset within one contract.

Options are also divided into several varieties:

  • American option: the buyer can exercise this contract on any day during its validity period.
  • European option: this type of contract can only be exercised on the specified date.
  • Asian option: similar to a European option in that it’s exercised on a specific date, but the strike price is determined by the average price of the asset over the contract’s duration. This type of option typically doesn’t yield high profits but reduces the risk associated with price volatility.
Directions in Options Trading

Directions in Options Trading

Options trading can take place on an exchange or over the counter.

Over-the-Counter (OTC) Option

Entering into an OTC option contract requires the buyer to pay a fixed premium to the seller. Apart from this, the deal is made under free conditions, with no strict rules for buy–sell operations, usually not focused on reliable issuers, and lacks guaranteed execution due to the absence of a third party.

Exchange-Traded Option

On exchanges, options are presented as standardized documents containing the following information:

  • type of contract: European, American, or Asian;
  • volume of assets involved in the contract;
  • terms of execution and expiration;
  • premium amount, price range, and allowable price deviations;
  • restrictions and other additional details.

When entering into exchange-traded options, transactions are carried out through an intermediary — the exchange’s clearinghouse, which keeps track of contracts. It acts as the “third party” for each deal and charges a corresponding “exchange commission.”

Difference Between Options and Futures

Difference Between Options and Futures

A future is a derivative financial instrument similar to an option. Usually, futures offer higher returns but come with greater risks. Options, on the other hand, have lower risk because futures require both parties to fulfill the contract to buy or sell an asset at the end of the term, while options impose an obligation on one party and the right to refuse on the other. By paying only the option premium, a trader gains market access similar to a futures or spot position. Lower capital investment makes options an attractive means to improve trading results.

The table below summarizes the key differences between futures and options, helping to understand which of these instruments may be more suitable for hedging risks and various investment strategies.

Contract TypeDerivativeDerivative
RightsThe buyer has the right, but not the obligation, to buy or sell the underlying asset, while the seller is obliged to fulfill the contract termsBoth the buyer and seller are obligated to fulfill the contract terms
Opening CostThe seller is paid a premium for the optionThere’s no initial premium, but there is a margin (collateral) — initial margin
Contract VolumeFixedFixed
AvailabilityTraded on exchanges and through OTC dealsTraded on exchanges and through OTC deals
Term DurationFrom a few days to several yearsTraditionally, the minimum term is one month; the maximum is not limited
RisksLimited to the paid premiumPotentially unlimited
Strike PricePre-determined or calculatedNone
Execution TimingAt any moment during the specified term or only at the end of the termMandatory at the end of the term
Distinctive Features of Crypto Options

Distinctive Features of Crypto Options

The main difference between cryptocurrency and traditional options lies in ownership. When buying or selling an option on a digital asset, the parties don’t actually own the cryptocurrency. Instead, the trade revolves around the price fluctuations of the underlying asset. Essentially, traders are betting on whether the asset’s value will increase or decrease within a specified timeframe.

Other notable features of crypto options include:

  1. Market environment. Traditional options are predominantly traded on centralized exchanges or other regulated financial platforms. In contrast, crypto options can be traded on decentralized exchanges or through specialized DeFi protocols.
  2. Regulation. Traditional options are centrally regulated, adhering to rules and standards set by governmental financial regulators, ensuring a high level of transparency and investor protection. Meanwhile, crypto options exist in a legal gray area, with regulation varying by country and often being non-existent.
  3. Liquidity. Traditional options generally have higher liquidity due to the participation of institutional financial institutions. Cryptocurrency options, however, may face lower liquidity issues because of the smaller market size in terms of capital turnover and participant numbers.
  4. Pricing methods. The price of traditional options is usually determined using option pricing models like the Black–Scholes model. In contrast, pricing crypto options can be more complex, depending on various factors, including the cryptocurrency’s volatility and the current market demand.
  5. Trading hours. Cryptocurrency options can be traded around the clock since crypto markets never close, unlike traditional exchanges that operate only during business hours.
  6. Settlement speed. Traditional options typically follow a T+1 settlement cycle, meaning transactions are settled the next business day after the trade. In contrast, crypto options can have instant settlements or other execution times, depending on the specific exchange and contract terms.
  7. Historical data. The traditional options market has extensive historical data, which traders and analysts use for technical analysis to model and forecast trends. Cryptocurrency options, being relatively new, have limited historical data available.
  8. Contract standardization. Traditional options come with standardized terms and specifications across regulated exchanges, facilitating trading and comparison. On the other hand, crypto options often feature more flexible and non-standardized terms, depending on the specific exchanges and agreements between participants. This lack of standardization can complicate analytical capabilities, increase potential risks, and add overall complexity to trading contracts, especially for over-the-counter deals.

In essence, options give market participants the chance to profit from the difference between the underlying asset’s price and its current value, while also serving as a form of risk hedging. Options can diversify trading strategies and generate income even with minor market movements. Cryptocurrency options, like other types of digital assets, offer investors and traders unique opportunities that come with additional risks inherent to the crypto market.

Author: Helen Katz
#Finance #Investments #Trading