Crypto Options Tutorial - Advanced
In the last few articles, we went over the basic concept of options and introduced the Greeks. This time, we will provide you with some real-world tools in SignalPlus Toolkit and how these tools can h
Last updated
In the last few articles, we went over the basic concept of options and introduced the Greeks. This time, we will provide you with some real-world tools in SignalPlus Toolkit and how these tools can h
Last updated
In SignalPlus Toolkit, you will find a series of tools to display volatility related information of the options market from different angels, under the Volatility section - you can find more details regarding those tools HERE.
As discussed in the previous chapter, implied volatility projects the likelihood of future price changes in a given asset. Among the 4 factors (moneyness, time to expiry, and interest rate, implied volatility) that affect option pricing, IV is the only subjective component that can't be observed directly. Given an option price at a specific moment, as the other 3 objective factors are known, it is fairly easy to derive IV from option price by using the Black-Scholes Model (in the bonus section of the previous chapter!).
The benefit of using IV instead of dollar price to compare different options is evident - it is a simple percentage value and can be applied across different strike prices, expiration dates, and even underlying assets.
In a word, IV is one of the most important measures for options traders to gauge the market sentiment and we want to use IV to help us find hidden opportunities or manage upcoming risks.
The term structure of IV describes the pattern of options with the same delta exposure but different maturities. By comparing term structures, investors can visualize how option IV will change as time elapses. As per the chart below, longer tenor options currently have higher IV than shorter tenor options, implying that longer tenor IV will naturally drift lower as time passes.
By default, our system displays a standardized set of strikes. 25D Put represents a Put whose strike has been chosen such that the delta is -25%; 25D Call represents a Call whose strike has been chosen such that the delta is 25%. You can also choose a different delta representation for your purpose on the left side.
By observing the IV gap between different delta, investors can also gauge RR IV. RR is a portfolio of long call and short put at the same delta, which is commonly used for gauging market emotion. When call iv-put iv is lower, investors are trading put for downside protection. When call iv-put iv is higher, investors are trading call chasing up trend.
Volatility cone is a visualization of historical volatility variation ranges. It is a useful tool for predicting possible IV range.
The data is derived from a certain period (in 1 year period for the case below). The horizontal axis represents the size of the observation window in days while the vertical axis represents the annualised volatility. For a certain observation window, we can derive several different RV (realized volatility) values in 1 year period. Analyzing these RV values statistically, we can plot extremums and quantiles of RV in each observation window. Meanwhile, the dotted line represents the latest RV for each expiration period.
As you can see, the variation in annualized volatility is large when the window is small and gradually converges to a narrower range as there are fewer and fewer samples for longer observation windows. Despite extreme cases, it is observed that the latest RV usually stays between maximum and minimum RV and reversing around median for each observation window.
When we plot IV of various options with the same underlying asset and same expiration date but different strike prices, we often see a U-shape (or a smile) towards the polar ends of the curve. This means volatility increases as the option becomes increasingly in the money or out of the money.
However, please note not all options align with the volatility smile, especially in longer-term options. In the case below on a further expiration date, the smile is reverse skewed, ****meaning the IV for options at the lower strike price is higher than the IV at the higher strike price. This suggests that ITM calls and OTM puts are more expensive than OTM calls and ITM puts.
The most popular explanation for reverse skews is that investors are generally worried about market crashes and buy puts for protection (the snapshot below is taken shortly after BTC falls under $19,000). One piece of evidence supporting this argument is the fact that the reverse skew did not show up for equity options until after the Crash of 1987.
In conclusion, not all options align with the volatility smile. Fortunately, Model Volatility Smile provides you with a visualization to manage risk intuitively.
Let's expand the volatility smile a bit further, let's keep the strike price as the x-axis and IV as the y-axis and if we add different expiration dates as the z-axis, we get a 3-dimensional plot of the implied volatilities of the various options listed on different dates. This is called Volatility Surface. One quick alternative is that we usually translate different price points to the corresponding delta for calls and puts.
Through volatility surface, it becomes even more clear to the traders how IV shifts as price/delta and time to expiry change.
Longing options is straightforward - in most cases, including cryptocurrency tradings, simply pay your premium upfront (where in some asset classes, you may be charged in a different arrangement), then if the asset moves into your option’s range of exposure by expiration time, you win! And if reality diverges from your expectations, the most you lose is the premium you pay.
So the first section is designed to list the long strategies that are prebuilt in SignalPlus Toolkit.
A long straddle strategy involves buying a call and a put option for the same asset with the same strike price (usually near or at the money) and the same expiration date simultaneously. An investor will often use this strategy when they believe the price of the underlying asset will move significantly out of a specific range, but they are unsure of which direction the move will take.
In a long strangle options strategy, the investor purchases a call and a put option with a different strike price: an out-of-the-money call option and an out-of-the-money put option simultaneously on the same underlying asset with the same expiration date. An investor who uses this strategy believes the underlying asset's price will experience a very large movement but is unsure of which direction the move will take place.
Strangles will almost always be less expensive than straddles because the options purchased are out-of-the-money options.
P&L for buying and selling options at the same time may be a bit more complicated, as you are paying and receiving premiums at the same time. In addition, you will face stricter margin requirements and need to post more collateral before selling any options, because your short position has a much greater downside and can be forced to liquidate.
Again, using some of these leveraged positions in trading can be highly risky and it is possible to lose your entire collateral if the price moves too far away from your target. However, at times, these combinations can be extremely attractive and financially rewarding in cases where options are mispriced. Luckily, in our SignalPlus Toolkit, we have more prebuilt strategies to help you manage your risk and reward properly.
Call or put spreads involve simultaneously purchasing and writing an equal number of options on the same underlying asset, same option type, and same expiration date. However, the strike prices are different.
This trade is less risky than an outright purchase, though it also offers less of a potential reward. It is used when either a moderate rise or fall in the price of the underlying asset is expected.
There are two types of spreads, bull spreads (benefiting from the underlying rising) and bear spreads (benefiting from the underlying dropping), which could both be implemented using call and put options. Below are 2 demonstrations.
Bull Call Spread
In this example, on September 5th when BTC is at $19,871.70, an investor believes the price will increase moderately within the next 26 days, but doesn't want to risk too much if the bet is wrong. So he decides to enter into a bull call spread with an expiration date of September 30th.
In this structure, the investor will buy a call with a strike price of $19,000 for $1,860 and also sell a call at $22,000 for $560 at the same time, totaling a net cost of $1,300.
Scenario 1 - if BTC price goes up slightly to $21,000 on September 30th, the long position will be worth $2,000 and the short position will be worthless. After the net cost of $1,300, the investor will pocket a profit of $700.
Scenario 2 - if BTC price goes up more to $23,000 on September 30th, because the underlying price is over the strike price of the short position, the loss on the short position will partially offset the gain on the long position. For a long position, the profit is $4,000 and for a short position, the loss is $1,000, so the payout is $3,000 and after netting the premium cost, the investor will have a final profit of $1,700. Note that any further increase in price will not increase the spread's value, as any gain and loss will cancel out above and beyond the higher strike price.
Scenario 3 - assume the investor is wrong and BTC price goes down to $18,000 on September 30th, because the underlying price is under the strike prices of both long and short positions, both positions will expire worthless. Maximum loss for any price below the lower strike price will be a constant of the net premium of $1,300.
Bear Put Spread
In this case, on September 5th when BTC is at $19,743.66, although not confidently, a different investor feels the price will continue to drop within the next 26 days. So he structures a bear put spread with an expiration date of September 30th.
In this structure, the investor will sell a put with a strike price of $19,000 for $1,025 and also buy a put at $21,500 for $2,400 at the same time, totaling a net premium cost of $1,375.
Scenario 1 - if BTC price goes up to $21,000 unexpectedly on September 30th, the short position will be worthless and the long position will be worth $500. After the net cost of $1,375, the strategy costs the investor $875.
Scenario 3 - assume the investor misread the market and BTC price goes up to $23,000 on September 30th, because the underlying price is above the strike prices of both long and short put positions, both positions will expire worthless. Maximum loss for any price over the higher strike price will be a constant of the net premium of $1,375.
Scenario 2 - if BTC price goes down further to $18,000 on September 30th, because the underlying price is below the strike price of the short position, the loss on the short position will partially offset the gain on the long position. For a long position, the profit is $3,500 and for a short position, the loss is $1,000 - so the payout is $2,500 and after netting the premium cost, the investor will have a final profit of $1,125. Note that any further decrease in price will not increase the spread's value, as any gain and loss will negate under the lower strike price.
The Butterfly option strategy is a neutral options strategy that has very restricted risk. The trader can earn a regular amount of profit with very low risk if designed properly.
It involves a combination of bull spreads and bear spreads. A holder merges four options contracts having the same expiration date at three strike price points, which can create an attractive price and gain some profit for the holder.
In order to construct a butterfly, a trader can buy two call option contracts, in which one at a higher strike price (Out of the Money) and another one at a lower strike price (In the Money) and sells two call option contracts at a strike price within (At or Near the Money).
To be more specific, in the example above, when BTC is at $19,776.71, we can buy 1 call at $17,000 for $3,300 and another call at $23,000 for $350. At the same time, we need to sell 2 calls at $20,000 for $1,290, totaling a net premium cost of $1,070.
If BTC price rises beyond $23,000, the payout of the long calls will be fully offset by the payout of short calls, so the total loss will be the premium cost of $1,070.
If BTC price drops below $17,000, all the calls will expire worthless, so the total loss will also be a premium cost of $1,070.
If BTC price moves between the lower and upper strike price bound, the payout will move like the summation of the bull spread and the bear spread. Max profit will be met at the strike price in the middle, as the payout of the bull spread position is maximized ($3,000) and the payout of the bear spread position is 0. After netting the premium cost, the max profit is set to be $1,930.
Similar to butterfly we mentioned above, the condor is constructed by a bull call spread and a bear call spread. Instead of overlapping strike prices in the middle, the condor strategy requires 4 strike prices - 2 being OTM and 2 being ITM.
Since this is not much different from the call spreads and butterflies, I will leave the detailed calculation to the readers. In the instance above, the max gain of $1,050 is achieved when BTC price falls between 2 middle strike prices, and the max loss of $950 is hit when BTC price goes outside the outer strike prices.
As we see earlier in the call/put spread section, the structure can be accomplished by either call or put options. Substituting the bull call spread by bull put spread, we can change the regular condor above to an iron condor without changing its payoff diagram. Again, there are 4 distinct strike prices for 2 puts and 2 calls, and all the options have the same expiration date.
Risk Reversal Strategy consists of a long call and a short put option for the same size and with the same expiration date.
It can be used as means to protect or hedge an underlying position using options. If an investor longs a stock, they could create a short risk reversal strategy to hedge their position by buying a put option and selling a call option. Buying a put would limit the downside of the portfolio, and selling a call would reduce the net premium cost but also limit the upside as well.
It can also be used to gauge the movement of a particular asset. You can consider risk reversal as the difference in implied volatility of similar call and put options. Implied volatility is indirectly related to the demand for call and put options. In the case above, as BTC falls under $18,000, the market has a huge need for downside protection, meaning IV for puts is much higher than for calls. As a result, the price for sold put is higher than for bought call, making the net premium received from risk reversal positive. This part will be explained more in Advanced volatility risk: Rega and Sega.
A calendar spread is an options strategy that involves buying and selling an option on the same instrument with the same strike price, usually around at-the-money, but with different expiration periods. The purpose of the trade is to profit from the passage of time and/or an increase in implied volatility in a direction-neutral way.
A calendar spread is most profitable when the underlying asset does not make any significant moves in either direction until after the near-month option expires.
Actually, one precious advantage of options over other financial instruments is that they allow traders to express their views on different Greeks while controlling exposure to others. Below we will review these strategies from a different angle to see how these strategies are related to Greeks, or to say, different risks. Thanks to SignalPlus Toolkit, we can test it out and check real-time Greeks of these strategies!
Bull call/put spread provides buyers limited profit when the underlying price moves up and limited loss when the underlying price moves down. It can be easily seen that a bull spread should have a positive delta as it benefits from the underlying price increase.
Below is an example of a bull call spread. It is built from 1 long ETH-23SEP22-1200-C and 1 short ETH-23SEP22-1350-C.
On the other hand, a bear call/put spread provides buyers limited profit when the underlying price moves down and limited losses when the underlying price moves up. It is clear that bear spread has a negative delta.
Though different in exact payoff structure, straddle and strangle have similar characteristics. They both provide buyers positive profit when the underlying price deviates present price at expiration, regardless of the direction of the movement. The more deviated the price is, the larger the profit will be. Thus they are strategies with naturalized delta (regardless of direction) and high vega (profit from volatility).
Example 1:
A straddle is structured by 1 long ETH-30SEP22-1300-C and 1 long ETH-30SEP22-1300-P. In this case, as highlighted below, you can see this structure provides minimal delta and high vega.
Example 2:
A strangle is formed by 1 long ETH-30SEP22-1200-C and 1 short ETH-30SEP22-1400-C. As you can see, compared with a straddle, this strangle is cheaper in premium but also requires a wider fluctuation in price. Traders should consider their own optimal risk/reward preference and select corresponding strategies.
Alternatively, butterfly and condor provide buyers with positive profit when the underlying price stays close to the present price at expiration and negative profit when the underlying price swings too much. This trait makes butterfly and condor perfect strategies to short vega without worrying too much about delta.
Example 1:
A butterfly consists of 1 long ETH-30SEP22-1200-C, 1 long ETH-30SEP22-1400-C, and 2 short ETH-30SEP22-1300-C.
Example 2:
A condor is built by 4 call options: 1 long ETH-30SEP22-1100-C, 1 short ETH-30SEP22-1200-C, 1 short ETH-30SEP22-1400-C, and 1 long ETH-30SEP22-1500-C
As we have known, implied volatility is really complicated. It is not the same for options having different strikes, expiries, etc, due to traders' different expectations. Normally for each expiry, the ATM option has the lowest volatility, and options on different strikes or deltas form a volatility smile. The shape of the volatility smile continuously changes and thus provides lots of useful information for traders. Fortunately, all these changes can be broken down into three types:
Parallel shift: the overall volatility smile moves vertically up and down. This kind of volatility risk is irrelevant to strike or delta so can be directly gauged by Vega only.
Skew change: the left side and right side of the volatility smile change in different directions while the middle remains unchanged, or to say one moves higher and one moves lower. Skew change risk is gauged by Rega, which is the option value's sensitivity to the 25-Delta risk reversal. And you will see why below.
Curvature change: the left side and right side move in the same direction while the middle remains unchanged, making the volatility smile more steep or flat. Curvature change risk is gauged by Sega, which is the option value's sensitivity to the 25-Delta butterfly.
No matter how volatility smile moves, it is always a combination of these three types. Experienced traders are able to dissect changes separately and change their positions based on their expectations.
One amazing thing about the option strategies is that they are able to provide perfect opportunities for these volatility smile changes too! Here are some useful examples:
Straddle provides the most profit in a parallel shift. When the volatility smile moves vertically up, all long Vega options can benefit. What benefits the most must be straddle, since it is built by ATM options, which have the highest vega.
In order to take advantage of a skew change described in the picture above, one can buy an OTM put and sell an OTM call. Does it sound familiar? Yes! It is a short risk reversal! Actually, other than hedging, one of the most common uses for risk reversal is to benefit from skewness. When expecting the right side to go up and the left side to go down, traders will buy risk reversal; when expecting the left side to go up and the right side to go down, traders will sell risk reversal.
For a curvature change described in the picture, one can benefit from buying an OTM call and an OTM put at the same time. To do this, traders can either buy a butterfly or buy a strangle. The difference is that a butterfly shorts two more ATM options than a strangle. So when buying the same OTM call and OTM put, butterflies are cheaper than strangles. The trade-off is that butterflies only benefit from curvature change, not parallel shift, while strangles benefit from both. In some sense, butterflies are "pure" curvature-related strategies.
One more fun concept here is that, since risk reversal is used for skew change and butterfly for curvature change, traders would call skew change RR and curvature change Fly.
In this advanced chapter, we walked you through some common tools for you to better gauge IV. With all the tools and knowledge we learned previously, you are presented with a number of strategies and their components. What's more, through these strategies, you should be able to isolate each risk factor and Greek to manage risk exposures. Admittedly, there are definitely more areas to explore in the world of cryptocurrency options, but what we have shown you so far should prepare you sufficiently to start your further journey on your own. We will continue to post helpful articles and practical instructions for you to improve yourselves. Please stay tuned and we will see you down the road!
