Crypto Options Tutorial - Basics

Basics

Why Do We Use Options

Before we start, let's first take a look at how options can help achieve different investment goals.

Thanks to the versatility of options, you can essentially bet on any movement of the market or specific asset. If your prediction is correct, you can make money either the underlying asset goes up or down or even sideways, through options. Aside from versatility, leverage is another attractive feature - a small action in the underlying asset can lead to a much higher reaction in options, where you can gain control over a large chunk of the asset with a relatively small cash outlay. That's why options are sometimes the best weapon for opportunistic speculators.

Another function of options is hedging. Think of it as an insurance policy. One cannot always be right about the future, hence options can be an inexpensive way to protect your investment against downturns.

At SignalPlus, a leading options trading platform for cryptocurrency, our goal is "Democratizing Options for Digital Assets" and we would love everyone to understand and be able to utilize the option as an investment tool. In this article, we would start with the options basics and the building blocks that you need to fully explore the power of options. In the next few chapters, we will provide more advanced details such as option pricing, the definition of Greeks, and comprehensive strategies.

What Are Options

Options are leveraged financial instruments, known as derivatives. Their value is derived from the value of an Underlying Asset such as stocks, cryptocurrency, interest rates, and commodities. In their simplest form, options give the owners the right (but not the obligation) to buy or sell an underlying asset at a specific price on or before a certain date. You can in a way consider owning options like insurance policies to protect the owners from undesired outcomes in future events.

Different Types

First of all, let's go over some definitions of the options. Don't worry if certain concepts are not crystal clear to you. As we move ahead with detailed examples, they will become more apparent over time.

Call Options

Owning a call option allows you to buy an underlying asset at a designated price within a certain time frame. The cost you pay to own the contract is called Premium. The designated price is called Exercise Price or Strike Price. And the end date for exercising the option is called Expiration Date.

Note that for a single underlying asset, there can be a handful of options across multiple exercise prices and expiration dates for you to choose from. Each would serve a different purpose and have a different value.

A good way to remember is that: the buyer has the right to “call” the asset away from somebody.

If you sell a call AND if the call buyer decides to exercise their right, you have the obligation to sell the asset at the agreed-upon price within the agreed-upon time frame. Please note that the price of the asset can theoretically go infinitely high, so in this case, you have to buy the asset at an extremely high price and sell it to the counter party much lower, thus incurring a loss as high as infinite. Therefore, for option sellers, it is required to maintain collateral/margin to cover possible extreme losses.

Let's use a quick example to show the scenarios of buying a call option -

Call Option Example

On September 1st, when BTC is at $19,900 (underlying price), you bought a call option with a strike price of $20,000 and an expiration date on September 30th for a premium of $1,460.

• Scenario 1 - on September 30th upon expiration, BTC drops to $18,000. You, as a rational investor, would choose not to exercise your option, because you can buy BTC at a market price of $18,000, which is cheaper than your strike price. Overall, you would only lose your premium of $1,460.

• Scenario 2 - on September 30th at expiration, BTC increases to $21,000. Thanks to the option you own, you can buy cheaper BTC for $20,000, which essentially would result in a gain of $1,000 (underlying price $21,000 - strike price $20,000). But given the premium you have paid upfront, you still have a net loss of $460.

• Scenario 3 - on September 30th at expiration, BTC is on fire and shoots to $55,000. Because of the option you own, you can buy cheaper BTC for $20,000, which would result in a gain of $35,000 (current price $55,000 - strike price $20,000). Even considering the premium you have paid, you still would gain a net profit of $33,540 for a cost of $1,460!

Long Call Option

SignalPlus allows users to view P&L intuitively

In a word, by buying call options, you can participate unlimited upside without actually owning the asset, as you can buy the underlying asset at a predetermined amount regardless of how high the price rises. Your only downside would be the premium you pay to own the contracts.

Put Options

Opposite to a call option, a put option allows you to sell an underlying asset at a designated price within a certain time frame. Everything else is similar and should be fairly intuitive once you fully understand call options. A good way to remember is that: the buyer has the right to “put” the asset to somebody.

If you sell a put AND if the put buyer decides to exercise their right, you have the obligation to buy the asset at the agreed-upon price within the agreed-upon time frame. Please note that similar to selling call options, your loss can be extremely hefty, as you need to buy the asset at a much higher price, even though the asset value may be close to 0.

Put Option Example

On September 1st, when BTC is at $19,900 (underlying price), you sold a put option with a strike price of $20,000 and an expiration date on September 30th for a premium of $1,600. This is also called selling Naked Put because you do not have any long or short position of the underlying asset.

• Scenario 1 - on September 30th at expiration, BTC drops to $15,000. Even though the price is lower now, you are forced to buy BTC from your counterparty for $20,000. This would be equivalent to an immediate loss of $5,000. After the premium you earned, you would have a net loss of $3400.

• Scenario 2 - on September 30th at expiration, BTC moves up to $25,000. Obviously, your counterparty would not exercise the option; instead, they may sell their holding at market price. At the end of the day, you would earn a premium of $1,600.

Generally speaking, for traders, there are 2 main motivations to sell Naked Put -

Short Put Option

SignalPlus allows users to view P&L intuitively

1. is to bet against the buyer, assuming the underlying price would rise above the strike price, and you can therefore pocket premium revenue after the option becomes worthless/nearly worthless;

2. You have an ideal entry point of the underlying asset so that you sell the put at the target exercise price. If the option is triggered, you could own the asset at the price you want with some kicker from the premium earned.

Exotic Option

Call-and-put options are often called Vanilla Options, because they are plain & simple and everyone likes them, just like vanilla ice creams! However, there are also Exotic Options that are different from traditional options in their payment structure, expiration dates, and strike prices. These options are usually more flexible to meet the various needs of the investors, but can be costly or only found in the over-the-counter (OTC) market. Examples include Binary Option, Barrier Option, Asian Option, Basket Option, Bermuda Option, etc.

Additional Concepts

American-styled vs. European-styled

If you can exercise your rights at any time up till the expiration date, the option is called American-Style. Otherwise, you can only buy or sell the asset on the expiration date, which is called European-Style. Currently, most options in the cryptocurrency exchanges are European-styled.

Moneyness

Moneyness is a description of an option relating its strike price to the price of its underlying asset. Simply put, moneyness tells option holders whether exercising right away will lead to a positive payoff. When an option is in the money, you will have a positive payoff upon exercising the option; when an option is at the money, you will break even upon exercising the option; when an option is out of the money, you will have a negative payoff upon exercising the option. Please note that the payoff does not necessarily mean positive profit for the entire trade. One needs to take the premium paid into consideration to calculate the overall profit for the position.

Call Option	Put Option
Strike Price < Underlying Price	In-The-Money (ITM)	Out-Of-The-Money (OTM)
Strike Price = Underlying Price	At-The-Money (ATM)	At-The-Money (ATM)
Strike Price > Underlying Price	Out-Of-The-Money (OTM)	In-The-Money (ITM)

Long/Short

Instead of measuring the distance or length of an object, Long implies owning(buying) a position of an option, and Short means selling a position of an option.

Intrinsic Value

This is the payoff the owner can get if an option is executed right away. Obviously, only in-the-money options have intrinsic value.Intrinsic Value and Time Value add up to the total value of an option.

Time Value

Basically, this is the part of an option value that is based on the risk during its time to expiry. Consider the value of an insurance policy. Time value is the price you pay to cover the uncertainty during a specific period (for example, the cost of health insurance covering medical expenses for 2 years is higher than a similar policy that only lasts 1 year).If an option has no intrinsic value (i.e., it’s out-of-the-money), its entire worth is based on time value. And obviously, if an option is about to expire, its time value will be zero.

Option Settlement

As we know, the buyer of an option has the right but not the obligation to buy or sell an underlying asset. When the buyer exercises the right, the sellers will have to deliver or take delivery of what they are contractually obliged to. This is called option assignment.In a lot of the cases in the cryptocurrency world, cash settlement instead of physical delivery takes place, meaning that at expiry, the writer of the options contract will pay any profit due to the holder, rather than transfer underlying assets.

Hedging Underlying with Options

As we mentioned at the beginning, hedging can be a useful tool for your investment. It is used to reduce risk exposure if an asset in your portfolio may be subject to a sudden negative price move. When performed properly, hedging strategies reduce uncertainty and limit losses without significantly reducing the potential rate of return.

Options can be used effectively as a hedge. A put option gives you the right to sell an asset at a certain price if the underlying asset begins to move lower. Let's review an example below -

Protective Put

Suppose you have 1 BTC from one of your smartest investments a long time ago. On September 1st, when BTC dropped to $19,900, you were afraid that the price may plunge further, so you bought a put option with a strike price of $18,000 and an expiration date on September 30th for a premium of $800. This strategy is called buying Protective Put, as your position is protected by the put you acquire.

• Scenario 1 - on September 30th at expiry, due to the economic downturn, BTC collapses to $10,000. Fortunately, you could exercise your option and sell your BTC for $18,000. In this case, for the duration you own the contract, the adverse price action only costs you $2,700 (including the premium you paid) vs. $9,900 without the put option.

• Scenario 2 - on September 30th at expiry, BTC bounces back to $25,000. Because of 1 BTC you own, you would make a $5,100 gain on BTC during the period. Even after the premium you paid, you still have a net gain of $4,300.

In short, when you buy a put option after owning the underlying asset, the put option works as insurance to protect you from the downside you are reluctant to take, at the cost of the premium. In the meantime, you can still enjoy the upside if the price moves in your favor.

Option Summary Table

Reason/Expectation	Max Gain	Max Loss
Long Call Options	Underlying will go up decently	Unlimited	Premium
Long Put Options	Underlying will go down decently	Strike minus Premium	Premium
Short Call Options	Underlying will go down or just go up a little	Premium	Unlimited
Short Put Options	Underlying will go up or just go down a little	Premium	Strike minus Premium

How to Read Option Quote

Now we understand the basics of the options - it's time for us to utilize the knowledge and read a real-world quote from SignalPlus Toolkit. As marked, the quote contains some basic information as well as some more advanced info, which we will cover in the later chapters.

A) Bybit is the exchange that you connect for this particular trade - SignalPlus allows you to connect to different exchanges for your trade. BTC is the underlying asset which is measured in USDC; 30SEP22 is the expiration date Sept 30th, 2022; 20000 USDC is the strike price; P is short for put whereas C is short for a call.

B) indicates the underlying price is at 19,996.88 USDC at the particular moment.

C) is the price you would put out for this particular option trade.

D) is the quantity of options you would like to execute.

E) is an order book showing the existing orders in the market. Red are Ask prices, which are the prices and quantities sellers are willing to sell. Green is Bid prices, which are the prices and quantities buyers would pay. The gap between Highest Bid and Lowest Ask is commonly known as Bid-Ask Spread. It is normally a good sign of Liquidity if the spread is narrow because the deal is closer to being executed between sellers and buyers. When bid and ask meet, orders will be executed.

F) controls the long/short position you would like to take.

G) Mark price of an option contract is the current fair value of the option as calculated by the internal risk management system. Usually, this is near the mid-point of the best bid and best ask price. However, for risk management purposes, there is price bandwidth in place.

How to Read Option Chain

An options chain is a table displaying options quotes for a particular underlying asset. The options chain matrix is updated in real-time showing the information related to each option, typically categorized by strike price and segmented by expiration date. The option chain is also symmetric over the strike price in the middle - left are the calls and right are the puts.

Below is an example of a BTC option chain on SignalPlus.

A) shows the selected expiration date for the options listed below. And you can choose different expiration dates for your preference.

B) shows there are 22 days till the selected expiration date of September 30th, 2022, and the current price for the underlying asset (BTC in this case) is $19,222.47

C) shows the bid/ask information regarding a specific strike contract. Last is the price the last contract is booked. Bid Size is the size of the highest bid whereas Bid is the highest price buyers are willing to pay. Ask Size is the size of the lowest ask whereas Ask is the lowest price sellers are willing to receive. Mark price is the current value of an option based on the internal risk model, which is usually near the midpoint of bid and ask.

D) shows the strike price in this row.

E) Position is your current holding in the portfolio of the specific contract.

F) Open is the current amount of active contracts in the market

G) ATM draws the line for moneyness. The top left and bottom right quadrants are ITM and the other 2 quadrants are OTM.

Summary

In this article, we went over basic terms and provided some simple examples of the options. Hopefully, now you have some good feelings about why people love options and how options trading can enhance profit & provide protection in your portfolio! In the next part, Options Intermediate, we will go through more details about option pricing, introduce Greeks to you, and more real-world option trading tools.

Bonus Section: A Brief History of Cryptocurrency Options

There are plenty of good options traders who don’t know anything about the history of options. But we’ve included this section for those inquisitive souls with the drive to learn everything possible about whatever subject they choose to study.

Tulip Mania of the 1600s

In the early 1600s, tulips became extremely popular as a status symbol in Holland. And as their popularity began to spill across Holland’s borders to a worldwide market, prices went up dramatically.

The trading of options then emerged naturally and reasonably - to hedge risk in case of a bad harvest, tulip wholesalers began to buy call options, and tulip growers began to protect profits with put options. But as the price of tulip bulbs continued to rise, the value of existing options contracts increased dramatically. So a secondary market for those options contracts came up among the general public.

Unfortunately, when the Dutch economy slipped into recession in 1638, the bubble burst and the price of tulips plummeted. Many of the speculators who had sold put options were either unable or unwilling to fulfill their obligations. (this is called Counterparty Risk) And options managed to acquire a bad reputation that would last for almost three centuries.

U.S. First Option Market

In 1791, the New York Stock Exchange opened. Shortly after the opening, stock options began to emerge amount the traders. However, in those days, a centralized marketplace for options didn’t exist. Options were traded “over the counter,” facilitated by broker-dealers who tried to match option sellers with option buyers. Interestingly, most of the option information was posted as advertisements in newspapers.

Eventually, the formation of the Put and Call Brokers and Dealers Association, Inc., helped to establish networks that could match option buyers and sellers more efficiently. But the structure of each option contract still had to be negotiated between the buyer and seller individual. In addition, there was no liquidity in the market - once you owned the option, you’d most likely have to wait to see what happened at expiration. Not to mention there still existed quite a bit of risk that sellers of options contracts wouldn’t fulfill their obligations.

Standardization

In 1968, the Chicago Board Options Exchange (CBOE) was created as a spin-off entity from the Chicago Board of Trade (CBOT), one of the first licensed national securities exchanges. The new exchange set up rules to standardize contract size, strike price, and expiration dates. Later on, along with Options Clearing Corporation (OCC), the exchange also established centralized clearing to ensure that the obligations associated with options contracts are fulfilled in a timely and reliable manner.

In 1973 Fischer Black and Myron Scholes published an article titled “The Pricing of Options and Corporate Liabilities” in the University of Chicago’s Journal of Political Economy. The Black-Scholes formula was based on an equation from thermodynamic physics and could be used to derive a theoretical price for standardized options. It was almost immediately adopted in the marketplace, and its publication was a massive part of the evolution of the modern-day options market. In fact, Black and Scholes were later awarded a Nobel Prize in Economics for their contribution to options pricing!

Growing into Popularity Today

The next major event was in 1983 when index options began to trade. This development proved critical in helping to fuel the popularity of the options industry. Today, there are more than 50 different index options, and since 1983 more than 1 billion contracts have been traded. 1990 saw another crucial event, with the introduction of Long-term Equity AnticiPation Securities (LEAPS). These options have a shelf life of up to three years, enabling investors to take advantage of longer-term trends in the market. Today, LEAPS are available on more than 2,500 different securities.

In the mid-’90s, web-based online trading started to become popular, making options instantly accessible to members of the general public. This was a brand-new era of instant options gratification, with quotes available on demand, covering options on a dizzying array of securities with a wide range of strike prices and expiration dates.

Today, it’s remarkably easy for any investor to place an options trade. There are an average of more than 39 million options contracts traded every day on more than 3,000 securities in 2021, and the market just continues to grow. In fact, in July 2020, single stock options trading volumes are bigger than shares volumes for the first time based on research from Goldman Sachs.

WallStreetBets

Reddit is a social media platform where members can engage in discussion threads about various topics. As you may or may not know, Reddit’s forum is broken into various subreddits, each one dedicated to a particular topic of discussion. The subreddit Wallstreetbets is a space where stock market investors can talk about investment ideas.

In Jan 2021, the site gained its popularity through Gamestop (GME) incident. Within a couple of days, the GME stock rallied from $20 per share to $483, fueled by the participants of the forum. The rally caused a handful of hedge funds, who bet the stock would go down, to suffer massive losses. The incident proved that young investors on Wallstreetbets, who are mostly not averse to risk and who may view day trading as an opportunity to improve their financial situation, along with other retail investors, are playing more and more impactful roles in the financial market. During the event, highly speculative options (mostly calls) were heavily used. In fact, because so many calls were sold to retail investors, the dealers or counterparties needed to buy the underlying shares to hedge their option open positions. This demand further increased the price of GME in the short term, creating another feedback loop to amplify price movements. This phenomenon is called Gamma Squeeze.

This event is just a tip of the iceberg that traditional finance relationships among retail investors, large institutions, and exchanges are rapidly evolving, thanks to the development of the online trading platform and the reduction of trading costs.

The Emergence of Cryptocurrency

Modern cryptocurrencies were first described in 1998 by author Wei Dai. The concept fully emerged in 2008 with the release of a white paper that explains the foundations of blockchain and bitcoin. The author of the white paper is “Satoshi Nakamoto,” which is presumably a pseudonym for either a person or group of people.

Bitcoin isn’t the only player in the cryptocurrency game. As its popularity began to rise, other currencies were released using similar blockchain technology. The most noteworthy Bitcoin alternative is Ethereum, which has the second-largest market cap in the crypto market.

It appears that cryptocurrency is on track for more widespread adoption. While there may be some changes and bumps in the road along the way, cryptocurrencies and blockchain technology are likely to continue to grow in popularity. Without a doubt, it’s now a risky investment opportunity that’s gathering interest and recognition across the world.

SignalPlus Vision

Options trading in the cryptocurrency market is still fairly new, and we see a lack of user-friendly options trading tools in this early stage. As a result, in 2021, SignalPlus was founded by a team of experienced market professionals and software engineers. The mission is to democratize crypto options use without a quality compromise while alleviating technical nuances that frustrate participation. To address this issue, we developed an industry-leading Trading Toolkit covering pricing, analytics, trading, and risk management all in a single dashboard. What is more exciting is the additional products provided by the team, including best-in-class Structured Products and AI-powered Market-Making Robot.

We hope through our products, our clients can not only participate but ignite the next explosive phase in crypto derivatives.