An Introduction to Options in Crypto
An overview for retail traders to utilize options strategies in their portfolio
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Intro to Crypto Derivatives
Derivatives markets are huge. In fact, the notional value of all contracts traded for traditional equities can amount to 1 quadrillion dollars.1 Although futures and forward contracts are the most commonly traded, options can be more lucrative, making them the most interesting financial instruments available to investors.
The cryptocurrency derivatives market, while still in its nascency, has shown to be no different. A recent study by Carnegie Mellon found that daily volume for crypto derivatives can exceed $100 billion, which beats the spot market by a factor of five.
Taking time to understand the intricacies of derivatives, specifically options, will allow investors to hedge their downside risk and speculate on future price expectations to amplify returns.
Option Use Cases
Hedging:
One of the main uses for options is to hedge downside risk. This can be done by buying a put, which has an increasing payoff as the price of the underlying decreases, or through more complex strategies that incorporate multiple option contracts.
Another benefit to hedging downside risk through options is to defer capital gains. Rather than selling the underlying, thus creating a taxable event, investors can maintain possession of their assets and nullify their position.
Collecting premiums:
Investors can also sell, or write, options. When purchasing an option, there is a premium paid based on a variety of factors known as “the Greeks”. As a seller of the contracts, you collect this premium in exchange for taking the other side of the contract.
Everything can go well with this strategy, but a quick shift in market sentiment can detonate your portfolio.
Speculation:
Speculation dominated trading activity in 2020 and 2021. This is simply betting a stock will go up or down. Because payoffs can be unlimited, there is a high amount of upside with a fixed downside (the premium).
Popular Decentralized Option Exchanges:
Ribbon:
Ribbon Finance offers a suite of vaults to store assets. Using either a covered call or put strategy, the vaults generate a yield from the premiums. Users can deposit their tokens as collateral which secure the contracts traded in the underlying. Due to this staking incentive, Ribbon has held the #1 options platform in TVL on DefiLlama for quite some time.
They also recently launched a vault for covered calls on Avalanche, which means there could be future development across other chains.
The option contracts generating yield are created and sold using Opyn, one of the largest options exchanges on the Ethereum network. All else being equal, this creates a positive feedback loop for available liquidity and TVL.
Opyn:
Opyn offers greater flexibility compared to other protocols by allowing the creation of new options contracts. Users will lock collateral, mint oTokens, and the option value is linked to those newly minted tokens.
The developer docs will give the full insight into the project, but these are ERC-20 tokens and can be traded on decentralized exchanges with sufficient liquidity.
Despite this, Opyn seems to be severely thin on available options. Of those that do exist, market depth is lacking. The recent sharp decline in price could be a contributing factor to low option volume.
Another red flag is that the options are European, which means they can only be exercised on the specified expiration. Regardless, Opyn has been developing its options products for quite some time now, and could continue to gain market share.
Lyra:
Lyra takes a gamified approach to the decentralized option markets. Along with the clean UI, the options priced using the Black-Scholes model, one of the most widely utilized pricing strategies for traditional equity options. With a centric focus on an AMM for implied volatility (IV), the options are generally priced more accurately.
Liquidity providers of the protocol are offered upwards of 30% for providing $ETH and $BTC. These funds are used to buy, sell, and collateralize the options traded. With this, comes the potential of gains and losses from the options traded on the platform.
Protocols that simplify options strategies for users (Ribbon), or focus on features of other DeFi exchanges (Lyra) will likely be at the forefront of new user adoption. But, platforms that offer deep liquidity and small bid-ask spreads will be able to serve more sophisticated options traders.
More Complex Strategies:
Below are a couple popular options strategies that go beyond single contract buying and selling. As market depth improves, look to these as possible opportunities to generate returns and protect losses.
Straddle:
A straddle is the simultaneous purchase of a call and put option, which creates the following payoff:
This strategy can be utilized any time the markets are extremely volatile, but the investor is unsure of the direction of movement. In traditional equities, popular times to create a straddle would be prior to quarterly earnings, unemployment statistics, shortly after a merger announcement, etc.
However, stock volatility is negligible compared to crypto. With sufficient market depth for options, and prices accurately reflecting trading activity, the premiums for this type of strategy will be significantly higher compared to stocks. The payoff chart will have a wider shaped “v”, requiring larger price movement to turn a profit.
Still, DEXes currently lack market depth, which could lead to inefficiencies and mispricing of options when trading volume increases. Those who capitalize these inefficiencies as they appear will be rewarded.
Collar:
A protective collar will limit the severity of both gains and losses. Here is the a look at the payoff:
The positions for a collar are:
Long the underlying asset
Buy a put at desired strike (protective put)
Sell a call at desired strike (covered call)
Theoretically, the premium earned from selling the call should cover the premium required to sell the put. In practice, however, prices can vary. Especially for the younger market of crypto options, always be aware of premiums.
This strategy will be beneficial to those who have caught a project early and earned multiples on their original investment. While locking in a floor price, investors can still utilize the project and benefit from further upside.
Risks Associated:
Using derivatives in crypto markets can amplify risk tenfold. But understanding payoffs associated with different option contracts will allow users to create effective strategies based on current market or asset conditions.
When writing calls and puts, there is no maximum loss. Theoretically, the price could continue indefinitely in either direction. Taking a position in the underlying asset or using a combination of derivatives can offset this potential for infinite loss.
Premiums are expensive. A “cheap”, or mispriced option, increases buyer demand and tightens supply, which brings us to a fairly priced option at market equilibrium.
Understand the difference between hedging and speculating. Futures contracts were first created for farmers to hedge potential losses due to a decrease in their crop price. There was no potential for gain, just the eradication of price risk.
Speculation on the other hand, will reward investors for being correct, and punish them for being incorrect. If an increase or decrease in price will severely alter your payoff, it is probably a speculative position.
Conclusion:
Continuously mentioned above, market depth for options is lacking on decentralized exchanges, and centralized exchanges offer a limited suite of derivatives for crypto with the least availability to US investors.
We are optimistic that there will soon be fast growth in the crypto options space. Whether it is through options specific protocol such as those listed above, or a major exchange like Uniswap, deep liquidity will allow investors to use various options strategies to improve portfolio returns.
Thanks for reading as always! I hope that this was a useful primer on options in the crypto markets. Have a great week!
Other Exchanges:
Opium has options on Ethereum gas prices, which allows users to hedge against a congested network and rising gas. It also introduced the first credit default swap in 2020, giving the ability to large institutions to hedge different kinds of interest rate and credit risks.
Hegic offers the premium for options to be given to the liquidity providers.
https://www.investopedia.com/ask/answers/052715/how-big-derivatives-market.asp