What is an Options Contract? How does it work?

Derivatives play an important role in traditional financial market as well as cryptocurrency industry that help investors optimize returns regardless of the volatility of the underlying asset. In particular, options contract is one of the popular derivatives.

Besides the benefits, options contract also carries a lot of risks. Therefore, before using this type of contract in trading, investors need to understand how it works to limit asset losses.

In the following article, Ecoinomic.io will provide an overview of options contract as well as strategies when trading options in the cryptocurrency market.

What is options contract?

Options contract is Derivative contracts that give investors the right to buy or sell assets at a specified price, on or before a predetermined date.

This is a derivative financial instrument that helps investors make speculative trading transactions, improve their position in assets. Besides, options contract is also hedging measure, helping to preserve available positions, limiting risks for investment portfolio.

Unlike futures contract, options contract does not require the investor to be obligated to take his position.

The value of an option contract is determined based on the value of the underlying asset in the market.

Naked crypto options

Naked crypto options contract is a risky investment when an user sells an options contract without owning any underlying asset.

Users have to collateralize a certain amount of asset to the broker before selling the options contract. When the crypto price moves contrary to the seller’s prediction, the risk of selling options contract is unlimited because the seller does not have the right to exercise the option of the contract, it is completely dependent on the decision of the buyer.

For example, an investor sells a 60-day BTC long naked crypto options for $10,000.

If the price of BTC rises to $20,000 in a day, the investor is still forced to sell BTC at $10,000 and suffer a loss of $10,000 if the buyer exercises the call option.

How does options contract work?

Suppose an investor pays a $100 fee to buy a BTC options contract for $1,000, the contract term is 60 days.

Investors have the right to buy BTC for $1,000 at any time within 60 days.

When BTC price in the market rises to $2,000, investor can execute the contract and profit from the $1,000 difference minus the $100 fee.

If the actual BTC price drops to $500, the investor may not exercise the option and incur a loss of $100 when buying the contract.

The buyer of the option contract can choose whether to exercise the option or not. However, when the buyer decides to exercise the option, the seller is obliged to pay his position.

The maximum loss of the buyer is limited to the fee when buying the contract, while the seller faces greater risk depending on the fluctuation of the market price at the time the buyer exercises the option.

Classification of options contracts

Based on the contract term

Options contracts are divided into 2 types:

American Style: The contract is executed at any time before the expiry date.
European type: The contract can only be settled at the time the contract ends.

Investors can choose a contract that suits risk appetite and the ability to identify market trends.

Based on rights to asset

Options contracts are divided into 2 types:

Call options: The owner has the right to purchase the underlying asset at a certain price before the expiry date.
Put options: The owner has the right to sell the asset at a set price before the expiry date.

Investors can combine two types of contracts to optimize profits depending on volatility of market. In fact, when predicting an uptrend in the price of the underlying asset, the investor usually exercises a call option, and vice versa, a put option is applied when the underlying asset price tends to fall.

The summary table below represents the rights and obligations of the parties to the call options and put options.

	Call options		Put options
	Holder	Writer	Holder	Writer
Right	Buy the underlying asset	Get an option premium	Sell the underlying asset	Get an option premium
Obligation	Pay the premium	Sell the underlying asset	Pay the premium	Buy the underlying asset

Options contracts — Call options and put options

Terms in options contract

Strike Price is the agreed price at which the investor has the right to buy (for call options) or sell (for put options) the underlying asset.
Size (Volume) of the order: the number of trading contracts.
Expiry Date is the date the contract expires, after this time, the option will not be able to exercise.
Premium is the amount that an investor must pay to secure options in a contract. The closer to the expiry date, the greater the volatility of the premium.
ATM (at the money): The current price is equal to the strike price.
ITM (in the money): The asset price is beneficial to those who own the contract. For call options, the strike price is lower than the market price. For put options, the strike price is higher than the current price.
OTM (out of the money): The price of assets is unfavorable to the owner of the contract. When it comes to a call option, the market price is lower than the strike price. On the other hand, the market price is higher than the strike price for a put option.
Spreads: Advanced trading strategies, options traders combine buying and selling multiple contracts at different strike prices.

Options execution fee

The options execution fee depends on the underlying asset price, strike price, remaining time as of expiry date, and the corresponding level of market volatility.

	Call options	Put options
High strike price	Fall	Increase
Short contract term	Fall	Fall
Large volatility	Increase	Increase
Asset price rises	Increase	Fall

Distinguish between options and futures contract

As common derivative instruments in financial markets, futures and options contracts both offer the opportunity to speculate, take long, short positions and make profits without actually owning any underlying assets.

Besides the similarities, they still have certain differences in terms of features, how they work and potential level of risk.

Features	Futures contract	Options contracts
Compulsion	There is an obligation to buy or sell the underlying asset at specified price when the contract ends. Even when the market goes against expectations, the position will automatically liquidate on the expiry date.	Have the option to buy or sell the asset at specified price at a certain time.
Contract purchase fee	No fees are required when purchasing contracts	Users purchasing a contract have to incur fee
Risks, opportunities	Risk is higher than options contract, the loss depends entirely on the actual market movement compared to the time of placing the order. Great profits.	Less risk. The maximum loss is limited to fee paid for the option contract. Lower profit compared to futures contract.

Advantages and disadvantages of options contract

Advantages

Speculate on the price of the underlying asset flexibly.
Hedging for available positions.
Combine multiple trading strategies with different reward and risk mechanisms.
Potential profit regardless of the market’s rising, falling or constant conditions.

Disadvantages

Complex trading strategies, operating mechanisms.
Users in short positions face many risks.
The market is illiquid, poorly attracting traders.
Fee fluctuates depending on the current asset price, the underlying asset, and the remainder of the contract. Near the expiry date, contract fee tends to decrease.

Basic options trading strategies

Hedging

Options contract is a hedging solution, allowing investors to preserve their holding positions. In case the market moves contrary to the investor’s predictions, they can give up the option exercise and only lose a fee to buy the options.

Speculating

Users can use options contract to make speculative trading transactions. For example, when an investor predicts the uptrend in the price of an asset, they can buy a call option. If the market price rises higher than the strike price, the investor can exercise the option and buy the asset cheaply.

Iron Condor

Investor will use four contracts: two calls (one buy and one sell) and two puts (one buy and one sell) with different strike prices and the same expiry date. Profits are obtained from small price movements. For example:

Buy a call option for $500
Sell a call option for $480 ($20 spread)
Sell a put option for $470
Buy a put option for $450 ($20 spread)

The maximum profit for Iron Condor is generated from the difference between the premium received and the premium paid.

Besides, the loss lies in the difference between the strike price of buying the put option and selling the put option, or the strike price of buying the call option and selling the call option. The maximum loss is calculated as the difference between inner and outer strike price minus net premium received

Where to trade crypto options?

Investors can look for options trading opportunities at reputable platforms such as Bybit, Deribit, OKEx and CME.

Deribit, CME only execute contracts at expiration and settle in cash, while OKEx does not allow contract settlement before the execution date and settles contracts physically. Deribit, OKEx and CME carry BTC and ETH options, while Bybit currently only has BTC options.

>> Related: Guide to sign up for Binance update 2022

Conclusion

Options contract is an effective derivative that allows investors to buy and sell an asset in the future, make speculative purchases, and develop hedging strategies.

Through this article, Ecoinomic.io hopes that you will understand more about the operating mechanism as well as the advantages and disadvantages of options trading. Therefore, you can build a risk management strategy, combine Fundamental Analysis with technical analysis to minimize losses and optimize profits.