Bitcoin Options: Trading Crypto Volatility

Bitcoin Options

Bitcoin is well known for its volatility.

Whipsaw price movements that defy most technical and fundamental studies. They catch traders off guard and leave them with their heads in their hands while scratching their heads.

While making price predictions on BTC can be tricky, there is a way to trade volatility and uncertainty in a risk-controlled manner. This is through the use of Bitcoin Options.

In this post, I will take a look at Bitcoin Options trading and how it can be used to your advantage.

But first, a short primer…

What Are Bitcoin Options?

For those with no financial background, options are asymmetric payoff derivative instruments. This means that, unlike Futures contracts, they do not have a linear payoff profile. Loss / Profit is capped based on whether you are long or short.

You have two types of options and they are a CALL and a PUT. The latter is an option to sell the asset on some future predetermined date at a predetermined price and the former is an option to buy. The predetermined price is called the “Strike Price” of the option.

When you are buying an option, you have to hand over a premium. This is your maximum loss on the option trade. In the below diagram we have the CALL option compared to a long future position and the PUT option compared to a short futures position.

Left: Long CALL and Long Future. Right: Long PUT and Short Future

As you can see, the maximum loss is the option premium and you have capped your downside risk in both cases. Of course, if you were the person that was selling the options then you would receive the premium and you would be exposed to unlimited downside risk.

Option prices are not just determined by the prevailing price of the asset at the time. They are driven by a number of other inputs such as the Implied Volatility (IV), time to maturity (t), Strike Price (K) and the prevailing interest rates.

All of these factors are collectively called the “Greeks” and they each impact the option in their own unique way. We won’t go into the theory behind option pricing as it is quite complex and beyond the scope of this text.

Benefits of Bitcoin Options

As you can see from the above images, the benefits of a long CALL / PUT are pretty obvious. You can take a view on the price of BTC while still capping your potential loss to the option premium.

For those traders who have traded Bitcoin futures before, you will be well aware of the unceremonious BitMEX liquidations that happen to highly leveraged positions. With a long option, you have more certainty around downside outcomes.

You could also use options to protect positions that you hold in your portfolio. They could also be used by Bitcoin businesses that need more certainty for the future price of BTC (think Bitcoin miners).

There are also a host of trading opportunities that are opened up through the use of option instruments.

For example, you can merely trade on whether you think Bitcoin is likely to be volatile or stable in the foreseeable future. This is generally because of the positive relationship between volatility and the price of an option (premium).

Relationship Between Price and Option Vol. Source: Investopedia

In the above image you have the general relationship between the prices and the volatility of the S&P500 (will be the same with any asset)

The BTC Options Markets

While Bitcoin has grown substantially in the physical and derivative markets, it is still relatively undeveloped in the options markets. There are really only two choices for you if you would like to trade BTC options.

One of these is through the OTC markets using a registered swap dealer. One of the most well known dealers on the market now is LedgerX. They are a CFTC registered Swap Execution Facility (SEF).

However, in order to trade with LedgerX, you need to be an “eligible swap participant”. There are a number of requirements you need to meet in order to be one but one of them is that you have at least $1m in liquid assets.

So clearly, they are beyond the reach of most retail Bitcoin traders.

However, there is a fairly established Bitcoin option and futures exchange called Deribit that offers retail BTC options. They are based in Holland and have been running since 2016. You can read more about them in this Deribit overview.

Ok, enough theory. Let’s take a look at some strategies.

Bitcoin Option Strategies

Option trading is a vast as it is complex and there is a plethora of different strategies that you can employ. While some are beyond the scope of this article, we will take a look at some of the most well known.

These are straddles, strangles and butterflies.

These are mostly used by traders who want to take a view on the volatility of the underlying asset with the price being ancillary to that.

Option Straddle

A straddle is a strategy where the trader will enter a position of a CALL and a PUT at the same strike price with the same expiry. If you are buying the CALL & PUT then it is a long straddle and if you are selling then it is a short straddle. Below is an image of the payoffs.

Long and Short Straddle Payoffs. Source: The Options Guide

As you can see from the above graphs, the long Straddle is Long volatility and the short straddle is short VoL. If there is a large movement in the price of BTC then you will make money with the long straddle and vice versa for the short.

So, for example, over the past month Bitcoin was really quite stable. The implied volatility was below that of even the S&P500. If you had entered a straddle you could have earned the return of the CALL and the PUT premium. Of course, if it had gone the other way you would have had an unlimited downside.

Most often, to get the full “delta” of the price movement in the option, the trader will strike the option at-the-money. This can be quite expensive as it requires purchasing both a CALL and a PUT. Taking a look at current pricing for expiry in a month from now, that would cost almost 10% of your notional.

Hence, in order to cheapen the cost of for the Long Vol trader and to lessen the risk for the short Vol trader, an option strangle trade is done.

Option Strangle

A strangle still involves entering two different option types but they are struck at different strike prices. They are both struck out-of-the-money so they are slightly cheaper to enter. The result is the payoff given in the below diagram.

Long and Short Strangle Payoffs. Source: The Options Guide

As you can see, the dynamics works much the same. The trader that is long volatility will get paid if there are extreme movements in the price of Bitcoin. However, there is a lower Delta in the position so the change in price will be less pronounced.

The short strangle position will get less initial payment for the options however they are protected from downside risk for a particular range of BTC prices. Yet, you are still exposed to unlimited downside risk in the event of extreme market moves.

How do you limit this?

Option Butterfly

Butterflies are constructed by using four different options. They can be implemented in a number of ways from using 4 different CALLs (two long two short) to using 4 different PUTs or a combination.

Below is an image of a long butterfly payoff. Perhaps quite confusingly, this is a short volatility strategy that is similar to the short straddle / strangle. This is in the below image on the left.

Long and Short Butterfly Payoffs. Source: The Options Guide

With this payoff, the trader that is short volatility will be protected from the downside risk that they could face with the straddle / strangle. In the case of the long volatility strategy, it can be called a short butterfly spread and it will have the payoff on the right.

While this may be slightly confusing to the uninitiated trader, there are a number of online resources that can help you understand these instruments better. For example, the options guide let’s you construct strategies and breaks them down into components.

If you wanted to try these out in a risk free way, Deribit also offers a demo account with demo funds on their test-net trading platform. If you do decide to trade them live, it goes without saying that these are still risky instruments and you should follow money management best practices.

Conclusion

The Bitcoin Options markets are the final frontier for a complete derivative market. They not only provide a method to limit risk but they also introduce a range of different strategies.

Indeed, given that the markets are still quite nascent, there are not that many outlets to trade them. Even on Deribit, there is a lack of liquidity in some of the Out-of-The-Money options.

However, as more financial institutions get involved in Bitcoin markets, you can be sure that option providers are likely to follow suit.

Perhaps we could one day even see CBOE listed and exchange traded Options.

Featured Image via Fotolia

Author:
Nic is an ex Investment Banker and current crypto enthusiast. When he is not sitting behind six screens trading Bitcoin, he is maintaining his numerous mining rigs. Twitter: @nicrypto