Options are financial contracts that give investors the choice (a right, not an obligation) to either buy or sell assets at a predetermined price (known as the exercise or strike price) by a certain date (known as the expiration date). Options are derivative instruments. That is, their prices are derived from the price of their underlying asset: stocks, bonds, commodities, currencies, indexes, etc. For the most part, bitcoin options are the same as any other options contracts: investors pay a price for the right to buy or sell a predetermined amount of bitcoin before an agreed date.
The options writer is the institution that creates the options contract and then sells it. The investor who buys the contract is not obligated to exercise it. If the investor chooses to exercise the option, the writer is obligated to fulfill the transaction by either buying or selling the underlying asset, depending on the type of option. If the investor chooses to not exercise the option, the writer gets to keep the premium (the price the options contract was originally sold for).
Most options are standardized contracts traded on options exchanges such as the Chicago Board Options Exchange (CBOE) or the Chicago Mercantile Exchange (CME). However, customized options contracts can usually be created upon request.
Investors generally buy options contracts for two main reasons: to speculate and to hedge risk. The fact that the investor who buys the options contract is not obliged to exercise the contract is the main fundamental difference between options and futures, and makes options less risky than futures for inexperienced investors.
There are two types of options: call options and put options
- Call options enable the contract holders to buy the underlying asset for a certain predetermined price before the specified expiration date.
- Put options allow contract holders to sell the underlying asset for a certain predetermined price before the specified expiration date.
Common options subcategories: over-the-counter, vanilla, European, American, exotic
- Over-the-counter options: Individually tailored options that are not listed on an exchange. They are generally traded between investors and investment banks.
- Vanilla options: Regular options contracts with no special features. European and American options contracts are considered to be vanilla options.
- European options: “Plain” vanilla options that can be exercised only on the specified expiration date.
- American options: “Plain” vanilla options that can be exercised at any time before the specified expiration date.
- Exotic options: The opposite of a vanilla options contract. They generally include complex features, terms or conditions. For instance, exotic options may have multiple triggers that determine profitability or have more than one underlying assets. Exotic options are generally traded over-the-counter rather than on traditional options exchanges.
What is a bitcoin options contract?
Bitcoin options are the same as any other call or put option contract where an investor pays a premium for the right to buy or sell a predetermined amount of bitcoin before an agreed date.
Buying a bitcoin options contract might help investors hedge risk. Should bitcoin’s price take an unforeseen turn, investors can simply choose not to exercise the bitcoin options contract and thus limit their losses.
One major difference between bitcoin options and other options contracts with more conventional underlying assets (such as stocks) is the price.
When pricing an option contract, the writer takes a look at the underlying asset’s implied volatility (an estimate of the asset’s future fluctuations). Implied volatility generally increases when the market is bearish and decreases when the market is bullish.
Since bitcoin is a highly volatile asset, bitcoin options are generally more expensive than other options contracts. During the bearish bitcoin market in March 2018, bitcoin’s short-term implied volatility was ranging from 90% to over 300%. To put things into perspective, during the financial crisis of 2007-2008, short-term implied volatility reached record highs of 65%.
Main differences between bitcoin options and bitcoin futures
- Bitcoin options and bitcoin futures put different obligations on the contract holder.
Bitcoin options give the investor the right, but not the obligation to either buy or sell a specific amount of bitcoin at a certain predetermined price at any time before the contract’s expiration date.
Futures contracts, on the other hand, obligate investors to either buy or sell a specific amount of bitcoin once it reaches a predetermined price on a predetermined future date.
- Another fundamental difference between bitcoin options and bitcoin futures is the upfront cost.
While investors can enter future contracts with no upfront costs, buying options contracts requires the payment of a premium. When it comes to bitcoin options, premiums are quite expensive, given bitcoin’s high implied volatility.
- Another major difference between bitcoin options and bitcoin futures is the size of the underlying position.
The underlying position is generally larger for futures contracts. Additionally, the obligation to buy or sell this larger amount at a predetermined price makes futures riskier than options.
Bitcoin options in the United States
Bitcoin options are not yet fully regulated in the United States, but they are sure headed there.
On October 2, 2017, the Commodity Futures Trading Commission (CFTC) cleared LedgerX, a digital-currency platform, for derivatives trading. The platform currently offers bitcoin options, among other financial products.
In December 2017, CFTC approved plans for bitcoin futures to be traded on two major officially regulated exchanges: the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE).
The favorable ruling gave bitcoin options further legitimacy. In March 2018, CBOE announced it was planning to expand beyond bitcoin futures and offer bitcoin options contracts, among other cryptocurrency-related financial products.
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