Options are a derivative that can provide leverage for speculation, risk protection for an underlying asset, flexibility to trade bi-directionally and a means to generate monthly income. However, there’s great risk* when options are misunderstood and misused.
This guide starts with the basics of options. It then covers more advanced trading strategies using a combination of spreads. Appended is a glossary of terms that are relevant to strategies covered in this guide.
*Strategies outlined in this guide have been adopted from the equities market and used since the early 1970s. Crypto options contracts are relatively new. They carry extra risks that must be considered—particularly when opening and closing positions. This guide is for educational purposes only.
Basic Concepts
Call options
Call option contracts give the buyer the right, but not the obligation, to buy a security or other financial asset at an agreed price (strike price) on or before a certain date (expiration).
“Why buy or sell a call option?” Here’s a simple analogy:
Imagine an asset like a block of land with a current value of $500k. Let’s say Person A (Ryan) owns the land. Ryan doesn’t think the land will appreciate any time soon.
Person B (Charlotte) believes there’s a big catalyst coming that’ll drive up the land’s value. She wants to get financial exposure to the land in case her belief becomes fact. Rather than buying the land outright for $500k, Charlotte buys a contract that gives her the option to buy the land at a future date.
Charlotte says to Ryan: “Give me the option to buy your land in 12 months’ time for $550k and, by agreement, I’ll pay you $10k for the contract granting me the right, but not the obligation to buy the land for $550k.”
Ryan agrees. Charlotte now controls the land for 12 months, but doesn’t own it.
Scenario 1: If the land is still worth $500k in 12 months, the contract is worthless. Ryan keeps the $10k premium he got for writing the contract.
While Charlotte lost $10k buying the contract, she didn’t need to risk $500k speculating in the market.
Scenario 2: Charlotte’s belief becomes fact. A big announcement has prompted developers to buy surrounding land. Ryan’s land appreciates by 20% and is now worth $600k.
Charlotte has the right to buy the land for $550k. She exercises her option, buying Ryan’s land for $550k. Charlotte then sells the land to developers for $600k. Charlotte’s net profit is $40k. That is, $50k minus the $10k she paid for Ryan to write the contract.
Scenario 2.1: Charlotte doesn’t want to exercise her option as she’d rather not deal with the land-buying process. Instead, she simply sells her contract to the developer for $50k, since this is now the contract’s real (intrinsic) value. Charlotte’s net profit is $40k.
Put options
Put option contracts give the buyer the right, but not the obligation, to sell a security or other financial asset at its strike price on or before expiration.
“Why buy or sell a put option?” Here’s a simple analogy:
Sarah buys a new car for $100k. As this is a big investment, she’d be silly to drive the car without insuring it first. Without insurance, Sarah could lose $100k if she has a bad crash.
Sarah gets an insurance policy for an agreed amount (strike = $100k) for an agreed period (expiration = 12 months). The insurer writes the contract (option) and charges a $10k premium for the agreement.
Scenario 1: 12 months pass. Sarah has driven sensibly and had no accidents. The insurance policy ends. To remain insured, Sarah must renew her policy for another 12 months, either at the same value or a newly determined value with a new expiration and premium.
Scenario 2: Sarah drives recklessly and crashes badly, writing off her car. Luckily for her, the crash happened in the 12-month insured period. Sarah’s policy covers her car’s value up to $100k. Sarah submits an insurance claim—that is, exercising her option—and gets $100k. Since she paid a $10k premium, Sarah was $90k better off relative to if her car was uninsured.
Summary
The above examples illustrate the concept of call and put options. The underlying mechanisms are more complex. (For more detailed explanations, see call options and put options.)
Once you understand the mechanics behind call and puts, you can learn how to create positions using combinations of calls, puts or both. These are known as ‘option spreads’. (Note, these are different to exchange buy-sell spreads.) There are many spreads, each varying in complexity and risk. A good way to understand the risk of spreads is by referencing risk graphs.
Risk Graphs
Risk graphs help you visualise the risks involved with a given position. You can use them to help you quickly decide whether a certain strategy is right for your circumstances.
Below is an example of a traditional U.S. equities risk graph for a debit spread.
The above risk graph depicts the ‘bull call spread’ strategy. Noteworthily, U.S. equity options control 100x shares of stock. Therefore, you must not build crypto options on a risk graph calculator like the above.
While there are other community-made spreadsheets that feature options risk graph calculators, be sure to understand how each leg plays a role in the spread.
Risk graphs for crypto options
Below are two solutions that give solid representations of risk graphs for crypto options—specifically BTC and ETH.
Option Spread Strategies
Part 1 of this guide covers the below strategies.
- Covered call: Moderately bullish, income-generating strategy to limit downside.
- Protective collar: Neutral position, used to hedge the underlying asset. Limited upside and downside.
The below debit and credit spread strategies are more complex. (To be covered in more detail in future.)
- Bull call spread: Bullish, limited risk, limited profit, debit spread.
- Bear put spread: Bearish, limited risk, limited profit, debit spread.
- Bull put spread: Bullish, limited risk, limited profit, credit spread (requires margin).
- Bear call spread: Bearish, limited risk, limited profit, credit spread (requires margin).
Below are the most advanced option trading strategies. (To be covered in more detail in future.)
- Long straddle
- Long strangle
- Calendar spread
- Diagonal spread
- Butterfly spread
- Iron condor
Covered Call Strategy
The covered call is a strategy where you own the underlying asset and sell a call option against the asset to generate monthly income. This is a good entry-level strategy that illustrates how time decay can work in your favour. There’s no risk of selling a naked call option because you’ve covered yourself by owning the underlying asset.
When you sell covered calls, you’re getting a weekly or monthly premium that your call option expires worthless. This is worth repeating: You want your short call options to expire worthless so you can keep the premium. For this reason, you’ll sell out-of-the-money (OTM) call options.
This strategy is good when the underlying asset is trading sideways—which is rather uncommon in crypto! The risk in the position lies in the underlying asset. That is, if the market corrected lower, the risk is the fall in the underlying asset’s price and not the call option you sold. Since you got a premium for the short call option, you deduct this amount from the loss.
Say you rolled out a covered call option strategy and collected a monthly premium of $300. After 3 months, the market corrects by $800. You’re still up $100 even though the underlying asset has depreciated by $800 since you opened the position.
Let’s try another example and explore it in more depth: You buy 1 BTC for $9,271. You sell a July 31 call at a strike price of $10k for $297 credit. The option expires in 23 days.
Scenario 1: BTC trades range-bound between $9,200 and $9,999. Time decay causes the contract to lose value as it nears expiration, before expiring worthless. You net $297 and repeat the process for the next month.
Scenario 2: BTC breaks above $10k. Your short call option is now in the money. However, because crypto options are European-style as of this writing, you’ll only get called away if your option contract is in the money upon expiration. And so, you can:
a) Do nothing and monitor the position in case BTC falls below $10k before expiration.
b) Buy back your short call to close the option contract and then ride your BTC’s upward move
c) Do nothing and get called away upon expiration. You net $297 plus $10k. You can also buy back in if the price surge was not too aggressive.
d) Roll up and/or roll out your short call position by buying it back and selling another call strategy closer to the money either at the same or later expiration.
Scenario 3: BTC falls below $9000. Your break-even point is $8,974 ($9,271–$297). This means that selling the call option has reduced your downside risk of BTC by ~3.15%. Therefore, you can:
a) Sell your BTC or HODL.
b) Put a put option to protect your downside risk. Thus, creating a protective collar position. In this example, a $9k put option cost $334, but remember that the closer to the money, the more valuable the option. Therefore, we can see that an at-the-money put currently costs $427 ($9,250 strike) and can assume that if the BTC moved to $9,000, this would also roughly be the price of the $9,000 put. Keep in mind, you already collected a $297 premium for selling the call, meaning you’ve created a protective collar position for $130 ($427–$297).
Protective Collar Strategy
A protective collar consists of buying a put option to hedge downside risk on the underlying asset, plus selling an OTM call option to finance the put purchase.
As mentioned, a protective collar can be executed after a covered call has been written by simply buying a protective put. Alternatively, you can open this position by simultaneously selling the OTM call and then buying the OTM put at the same time.
(As of this writing, no crypto exchange lets you open spread positions simultaneously. You must ‘leg in’ to a spread position—that is, entering into each position asynchronously. Hopefully a company like Paradigm can bring spread order books to crypto.)
As with covered calls, you’d use this strategy when you’re moderately bullish. But there’s an impending downside risk. Since you’ve already collected a premium on the covered call, there’s little to no cost to protect your underlying asset with a put. This creates a risk-mitigating floor and profit-capping ceiling.
If the impending downside risk is averted, you can let the put expire worthless. Or, if there’s any time value left, you could sell it to recover some credit.
In this way, you can continue the covered call strategy while bullish price action is slow and incremental, and turn the strategy into a protective collar when you foresee immediate downside risk.
Options pricing can be affected by other factors like implied volatility and time value. You must assess these factors when selecting OTM options. You can build positions on paper using 5% OTM options in either direction. This will get you close to delta-neutral. (Using a 5% higher strike price for the OTM short call and 5% lower strike price for the OTM long put.)
Glossary
American-style option: A contract that gives the holder the flexibility of exercising the option at any point between buying the contract and expiration.
Assignment: When the contract writer is required to meet their obligations under the contract terms. For example, buying (selling) the underlying asset if they’ve written calls (puts).
At-the-money option: An option where the underlying asset’s price equals the strike price.
Automatic exercise: The process by which ITM options are automatically exercised if they’re in the money at expiration. Sometimes referred to as ‘exercise by exception’.
Black–Scholes model: A pricing model based on factors including the strike price, the underlying asset’s price, the time until expiration and volatility. (More on the Black–Scholes model.)
Break-even point: The price or price range of the underlying asset at which a strategy will return no profit or loss.
Bear spread: A spread created to profit from bearish price action. (Bear spread strategies to be defined in a later part of this guide.)
Bull spread: A spread created to profit from bullish price action. (Bull spread strategies to be defined in a later part of this guide.)
Buy-to-close order: An order that’s placed when you want to close a short position through buying contracts you’ve previously written.
Buy-to-open order: An order that’s placed when you want to open a position through buying contracts.
Call option: A type of option which grants the holder the right, but not the obligation, to buy the relevant underlying asset at an agreed strike price.
Cash-settled option: A type of option in which any profits due to the holder at the point of exercise or expiration are paid in cash rather than an underlying asset being transacted.
Contract size: The number of units of the underlying asset the contract covers. Typical contract sizes are 100. Displayed prices are usually based on one unit of underlying asset. For example, if an option has a listed ask price of $2.00 and the contract size is 100, it’d cost $200 to buy a contract covering 100 units of the underlying asset. In crypto, one contract typically controls one unit of the underlying cryptocurrency.
Credit spread: A type of spread that’s cash-positive—you get more for writing the options involved in the spread, relative to what you’d spend buying them.
Debit spread: A type of spread that’s cash-negative—you spend more buying the options involved in the spread, relative to what you’d get for writing them.
Delta-neutral hedging: A strategy used to protect a position from small price movements. Can be used to hedge positions in stocks or other financial instruments.
Delta-neutral trading: A strategy designed to create trading positions which will neither profit nor lose if there are small movements in the underlying asset’s price, but will return profits if the underlying asset’s price moves significantly in either direction.
Delta value: One of the Greeks, the delta value measures the theoretical effect that changes in the underlying asset’s price have on the option’s price.
European-style option: An options contract that’s exercisable only at the date of expiration.
Early assignment: When the contract writer meets their obligations under the contract terms before expiration.
Early exercise: When an American-style option is exercised pre-expiration.
Exercise: The process by which the contract holder uses their right—as defined in the contract terms—to buy or sell the relevant underlying asset at the agreed strike price.
Expiration date: The date on which a contract expires and effectively ceases to exist. If options aren’t exercised on or before expiration, they expire worthless.
Expire worthless: When a contract hits expiration and has no value. That is, the contract is either at or out of the money at expiration.
Extrinsic value (EV): The component of a price affected by factors other than the underlying asset’s price, such as time left until expiration. (More on price of options.)
Gamma value: One of the Greeks, the gamma value measures the theoretical effect that changes in the underlying asset’s price have on the option’s delta value. (More on gamma.)
Greeks: A series of values that can be used to measure an option’s sensitivity to changing market conditions and its theoretical price changes caused by factors like the underlying asset’s price, volatility and time left until expiry. (More on the Greeks.)
Hedge / hedging: An investment technique used to reduce the risk of holding a specific investment. Options are widely used for hedging purposes; protecting another position or a position in another financial instrument.
Implied volatility (IV): A measure of the estimated volatility of the price of a financial instrument at the current time.
In-the-money (ITM) option: An option where the underlying asset’s price is in a favorable position relative to the strike price, meaning it has intrinsic value. A call (put) is in the money when the underlying asset’s price is higher (lower) than the strike price.
Intrinsic value: The component of a price affected by the profit that’s effectively built into a contract when it’s in the money. That is, the amount of theoretical profit that could be realised by exercising the option.
Leg: Used to describe the individual positions that make up an overall position.
Legging: The process of entering or exiting each leg of an overall position separately. (More on legging.)
Legging in: The act of entering multiple legs.
Legging out: The act of exiting multiple legs.
Margin: Changes depending on context. Regarding buying an instrument, margin is the process of borrowing capital to buy it. Regarding options trading, margin is the amount of cash required to be held in a trading account when writing contracts.
Naked option: Is created when the option seller doesn’t own any or enough of the underlying asset to meet the potential obligation that arises from selling the option. Also known as an ‘uncovered option’. Trading naked options requires a very high risk tolerance.
Near-the-money (NTM) option: An option where the underlying asset’s price is very close to the strike price.
Neutral trading strategies: Strategies that can be used to profit from the price of a financial instrument moving either slightly or not at all.
Option / options contract: The right to buy or sell a specified underlying asset at a fixed strike price within a specified period.
Out-of-the-money (OTM) option: An option where the underlying asset’s price is in an unfavorable position relative to the strike price, meaning it has no intrinsic value. A call (put) is out of the money when the underlying asset’s price is lower (higher) than the strike price.
Premium: Describes an option’s whole price or EV.
Risk graph: A graph showing a position’s risk-to-reward ratio. (More on risk graphs.)
Risk-to-reward ratio: An indication of how much risk is involved in a position relative to its potential profit.
Rolling down: The process of closing a position and simultaneously opening one with a lower strike price.
Rolling forward: The process of closing a position and simultaneously opening one with a prolonged expiration.
Rolling: A trading technique used to close a position and simultaneously open one with slightly different terms.
Rolling up: The process of closing a position and simultaneously opening one with a higher strike price.
Sell-to-close order: An order that’s placed when you want to close a long position through selling the contracts you’ve previously bought.
Sell-to-open order: An order that’s placed when you want to open a new position through writing new contracts.
Settlement: The process by which the contract terms are resolved when the option is exercised.
Spread: A position created by buying and/or selling different contracts on the same underlying asset to combine multiple positions. (More on options spreads.)
Spread order: An order type used to create a spread by simultaneously transacting all the required trades.
Strike price: The price specified in a contract at which the contract holder can exercise their option. The strike price of a call (put) is the price at which the holder can buy (sell) the underlying security.
Theoretical value: An option or position’s value as calculated by a pricing model or other mathematical formulae.
Theta value: One of the Greeks, the theta value measures the option’s theoretical rate of time decay.
Time decay: The process by which the EV diminishes as expiration nears.
Vega value: One of the Greeks, the vega value measures the theoretical effect that changes in the underlying asset’s IV have on the option’s price.
Volatility skew: When a graph shows the IV across options with the same underlying asset, but different strike prices form a curve skewed to right.
Volatility: A measure of how a financial instrument’s price is expected to fluctuate over a specified period.
Weekly option: An option type that uses a weekly expiration cycle.
Writer: The creator of new contracts to sell.
Writing an option: The process of effectively creating new contracts to sell.
A special thank you to Collective Shift Crypto Community member, Dave, for putting together the content for this crypto options guide.
When you’re done, check out Crypto Options Guide Part 2