Options for crypto investors (part 1)

Investors on traditional stock, commodity and FX markets have used derivatives in their strategies for decades. Futures are already present on crypto markets and the next big step will be options.

In a series of posts, I want to explore: 1/ what options are, 2/ the differences between options on stocks and on crypto, 3/ who offers options in crypto today and 4/ options strategies for various crypto players like fundamental investors, miners, exchanges, traders. Please note, this is not an ultimate resource, rather a thought starter. Crypto has redefined many things in the traditional finance world, no wonder if it also changed derivatives.

That being said, let’s begin. In this section you will find:

1. Basics on options and what drives them (if you are already familiar with options, feel free to skip this part)
2. Who offers options in crypto and how are stock options different from crypto using Bitcoin as an example
3. Ways to use options in crypto

You can find part 2 of the series here.

TECHNICAL UPDATE: the section on historical volatility and the Ledger product have been updated/fixed due to a bug in the calculation, which has lead to a somewhat false conclusion.

OPTIONS BUILDING BLOCKS

For those who are not familiar with options, there are numerous places to start. Almost all strategies are based on the core principles: a call option gives the buyer the right, but not the obligation to buy an underlying asset at a specified price [called strike price] on or before a pre-agreed expiration date. A put option gives the buyer the right, but not the obligation to sell an underlying asset at a specified price [strike price] on or before a pre-agreed expiration date.

Inversely, the seller of a call option gets paid to commit to sell the asset at the strike price if the call buyer exercises the option. The seller of a put option is paid to commit to buy the asset at the strike price if the put buyer exercises the option.

Option buyers benefit from unlimited upside and limited downside. Option sellers have the opposite asymmetry, and benefit if the asset price does not move. Why? Because as time passes, options lose value, all else equal. This is a crucial take away.

What happens at expiration?

On the expiration date, a call option is worth the difference between the underlying asset price and the strike price. Call buyers usually exercise their right if the price is above the initial strike price (the option is then called in-the-money), because they can buy at the strike price and sell at the current price on the market. Naturally, call buyers will not exercise the option if the asset price is below the strike price (called out-of-the money). A put option goes in the opposite direction: it is worth the strike price minus the asset price. Put buyers would exercise if the asset price is below the strike price, because they can sell the asset at the strike and buy at the lower market price.

Value of an option

To calculate the value of an option at expiration is straight-forward. What we care about is the initial value of the option and over time till expiration. This is where the concept of implied volatility comes into play. It is measured as an annualized one standard deviation move in the price of the asset. The value of an option is affected by the price of the underlying asset, the strike price, the time until expiration, and, in the case of stock options, the expected interest rate and dividends. The last, and probably, most important factor is the implied volatility. If we consider that all other inputs are either known upfront (strike, asset price) or kind of known (time horizon, interest rates, dividends), the implied vol is the real unknown.

Implied volatility is considered to give an estimation about the probability that the option will make money (be in-the-money) at the time when it expires and is related to how volatile the underlying asset is.

For example, let’s consider a call option with a strike price 2x higher than the current price (out-of-the-money) on the EUR/USD and a call on Bitcoin. Since the latter is much more volatile, you would want to buy the BTC call option because it is much more likely that BTC will double in price than EUR/USD. As a result, the market will price the two calls accordingly to reflect the difference — BTC options will be much more expensive.

Market participants typically use the Black-Scholes model to value stock options (given the variety of crypto asset types, I am sure other models will also be used coming from FX/bonds/commodities). Implied vol is therefore considered to be the metric used to compare and measure option prices between assets, time periods, strike prices etc, all else equal. Implied vol is typically stated in % (e.g. 25% vol) and option prices are typically shown in % of the price of the underlying asset (e.g. 5% of the spot price).

Implied vol changes can have large effects on option prices. Investors/traders can tailor their directional views with options and/or combinations of options. This is why it is important to figure out when an option is a good buy or a good sell. The analysis typically includes:

• Comparing implied vs. realized (historical) volatility. Historical vol shows how volatile the asset has been in the past. A view in the rear-view mirror may not be the best future indication, particularly in crypto, but it is always good to have a sense as to how the market sees the future compared to the past. Importantly, cum expiration, implied vol will converge to realized vol so the initial difference is important, because the buyer pays the implied and not the realized vol.
• Implied vol over time. Investors would want to see how implied vol changed over time and buy when it is low / sell when it is high. Data here is crucial and likely still not something we have in crypto.
• Events. Crypto is full of expected and unexpected events which should make options excellent instruments for navigating these. Typically, option prices tend to raise ahead of large catalysts when people expect significant price swings.
• Implied vol relative to sub-sectors and indexes. We are not there yet, but when we have better segmentation into baskets — store of value coins, smart contract platforms etc, we can compare vol relative to and across them.
• Buying/selling options with different strikes or time horizons on the same asset to express nuanced views.

Volatility and price direction

As I mentioned above, both historical and implied volatility are shown in the same units, an annualized one standard deviation move in the price of the asset. If the price of an asset increases by exactly 1% every day for 15 days, then volatility will be 0, because the daily returns do not deviate at all, but the price will be 16% higher. However, if the price moves +1% one day and -1% the next for 15 days, the annualized historical volatility will be 19.7%, but the price will be 1% lower in the end. This is to show that price and vol are not usually correlated. The 19.7% is calculated by taking the standard deviation of the +1%/-1% series of returns and then multiplying by the square root of 365 (the number of trading days). On stock markets, where there are ca. 252 trading days per year, traders have a rule of thumb to multiply by ~16. In crypto where markets are always on, the number would be ~19x. A quick mental model to imagine what a vol number of say 19% means is to divide by 19. The result (~1% in this case) means that the price is expected to move on average by 1% on 68% of all trading days (because we look at 1 standard deviation).

Time value

One of the main features of options is the time value. Investors should understand it well as this is something that distinguishes them from futures. When you buy an option, its value has two components — intrinsic value and time value. The intrinsic value is simply the difference between the strike and the current spot price of the asset. The time value is the difference between the option premium and the intrinsic value. Obviously, the longer the option term, the higher the time value because there is a better chance (at least in terms of time) for the asset price to reach and surpass the strike and hence — the higher the premium.

With the necessary basics out of the way, let’s look at…

OPTIONS IN CRYPTO LAND

The largest crypto exchanges do not offer options currently. This will change at some point, but for now, there is only one (that I found) which offers options as a product — LedgerX. The account requirements are severely limiting for the common person because it is tailored towards institutional investors and individuals from the US/Singapore with net assets > $10m. For lack of better alternatives, I will use one of LedgerX’s products as an example in one of the strategies below.

Smaller individual investors may soon be able to find options on decentralized exchanges and prediction markets where market makers can set up standardized and/or funkier option contracts. Augur is an obvious one and hopefully it gets there quickly.

It makes sense to do a quick comparison between options on stocks and options on crypto. I will use stocks and not FX because crypto is a very colorful asset class and I think there are more similarities.

What affects option prices

The below shows what factors affect option prices…

… and how, all else equal (even though it never is).

A few things to note here:

1. With stock options, changes in dividends are usually negligible unless these are unexpected and large. For example, Bitcoin does not have dividends, but there have been several forks which have similar properties — free cashflow for holders. The major difference is that price changes around fork announcements and fork days tend to be significant so this factor will be an important consideration for crypto options. The logic would be similar for airdrops on Ethereum. We can argue that staking is akin to a dividend because crypto is locked and produces a return. A recent analysis into forks by Alex Evans showed that value is not easily transferred by forking. Some forks carve out a niche and stick over time, stabilizing vs the parent coin. For example, BCH has been trading around 5–15% of BTC in the first few months after the fork so whomever held BTC then and sold, did receive a de facto one-off dividend yield. The important word here is one-off. An interesting dynamic is created here in which options in different years may or may not have a fork premium in their price depending on who the buyer/seller is.
2. The question of interest rates is more nuanced: call options on stocks increase in value if interest rates increase because one can replace a long stock position with call options and invest the freed up capital in t-bills till expiration. How does that apply to crypto? On one hand a long BTC holder can replace his position with physically delivered calls and free up capital. This capital can, in turn, be invested in a risk-free instrument on the traditional capital markets, in which case he can use the government risk free rate, similar to stock options. Alternatively, why not use the cash to loan it out on a crypto P2P platform which offers fully crypto backed loans? Generally, the rates you can get there could be akin to crypto “risk-free” rates. I think platforms like Compound and Dharma aim to become/facilitate the crypto money markets. Could staking be used as a risk-free interest rate? Unclear as it does not offer capital protection (vs. fiat or BTC). You can’t, for example, free up capital by replacing a BTC long with calls and stake the capital in Ether without being exposed to price risk. However, you also can’t replace ETH with calls on ETH and keep the funds in ETH to receive the staking %. As a result, what rate is used in crypto options can have a much larger effect on the price compared to stocks.
3. It gets even more interesting with crypto indexes, of which there are more and more now, because they can be much more liquid than individual coins. When, at some point, someone starts to make option markets on the indexes, people can play with many variables —correlation, sum-of-parts, forks, drops etc. Exciting times ahead, we’ve seen nothing yet :)
4. Historical volatility for Bitcoin has been very high. See below a chart of 1-year rolling historical volatility of Bitcoin (pricing data: Bloomberg). Historical vol is currently in the 90s, which is off its 2017 highs and much lower than the 2013 period. The line is smooth as it shows 1-year vol, meaning it takes the standard deviation of a full year worth of daily returns, which tends to eliminate daily or weekly spikes. In comparison, the 1-year rolling volatility of the S&P 500 index during 1950–2015 has been between 5–30%.

The much higher volatility of crypto assets makes them suitable for all kinds of option strategies, so let’s look at a few…

WAYS TO USE OPTIONS IN CRYPTO

Use the payoff asymmetry in options

Buying options offers unlimited upside exposure with capped downside risk and is often used ahead of important events. However, buyers need to be careful not to overpay for options, because implied volatility tends to rise ahead of big events and fall thereafter. Buying options certainly makes sense when their price (measured via implied vol) is reasonable. However, a higher volatility does not necessarily mean that an option is a bad idea. Remember, people have different motivations to buy options — to speculate, to reduce risk, to protect profits etc.

Let’s assume an investor holds Bitcoin and is worried about a price decline due to some event in the future. Currently, the options are limited to — holding and assuming the price risk or selling and risking a further price increase. By using options, the investor/holder can:

• Keep the long position and buy a put option, which would protect the investor at a known cost — the option premium. The below example shows buying an at-the-money (ATM) put option with a strike of $6,600 (spot price today is $6,600) for 11% ($750 premium — illustrative only, but not unrealistic).

• Sell the bitcoin and buy call options for the same amount while keeping the cash and risking only the premium. The payoff is on the chart above (the right one). Once the option has expired, if the price is higher the investor can buy back the position at the strike price and profit. If the price is lower, then buy at the lower price. However, there can be tax consequences.
• If selling is not optimal for tax reasons, an alternative may be to get a BTC backed loan and use the money to buy calls. If the price falls, the investor keeps the cash from the loan. This is a bit more complex as the cost would be the interest rate on the loan plus any option premium and that may be too high.

Consider a miner who receives regular deliveries of Bitcoin. They need to both manage their cashflows in order to cover operational costs and save for future capex, but also hold a reserve to capture future price increase. Currently, the futures market offers a way to hedge, but not that flexible and requires margin capital. The cashflow can be managed more efficiently using options. For example, the miner can buy ATM put options 3 or 6 months out to fix the selling price of incoming BTC should the market fall. If prices are higher, the option will expire worthless and the miner can hold or sell at the higher market price. In contrast, selling a futures would force a sale and also has a fair amount of upfront margin requirement, which increases with prices rising. Similarly, the miner could replace part of their BTC inventory with longer dated call options, thus protecting their operating margins in case the price declines and, at the same time, retain the upside.

Turning an eye to funds and traders, someone short BTC can hedge their position by buying call options, which is a particularly attractive strategy when vol is reasonable because crypto does not lack price spikes on the upside (whereas in traditional markets, larger down moves are more typical). Similarly, a short position can be replaced by buying put options as a speculation with limited risk.

There are various ways to further tailor these strategies by using a combination of options. I will look at some of those in the next posts.

As you can see, there are plenty of good reasons why someone would want to buy options. So why would anyone want to sell an option?

Well…

Fun fact — the majority of all options end up worthless at maturity. On the stock market, this number could be as high as 80% of all issued options. Not a bad reason to sell, but, as always, the devil is in the details. Even with this statistical advantage on their side, option sellers could be exposed to more risk than option buyers which has to be managed carefully.

Why do people sell options?

Sell covered calls

This is a very well known and popular strategy on the stock market. It involves owning the asset and selling out of the money options. This allows the investor to capture yield upfront by agreeing to sell the asset at a fixed higher price. There are plenty of reasons why someone would do that —1/an investor does not see further upside during the term of the option, 2/ volatility is elevated, 3/ the asset has rallied already and a trader expects a cooling off period, 4/ an investor has a price target where they would either sell anyways or at least reduce the position etc.

If the price rallies above the strike price, the call seller is forced to sell at the strike price, but keeps the premium. If the price remains flat or declines, the call seller keeps the premium they received upfront because the option will likely not be exercised.

Turning back to our miner, they can engage in a “mine-write” strategy where they sell call options on a portion of the newly mined BTC as a way to fund operating costs and guarantee a known exit price above the current market price. Note, this would not hedge any downside price risk, but provides a small cushion (the call premium received).

To illustrate, the miner can sell part of the newly minted BTC at the current price of $6,600, incurring taxes along the way and locking in profits. Instead, they can keep the BTC and sell out-of-the-money call options with a strike price of $7,000. They would receive a premium of $750 per BTC (again, made up, but not unrealistic) which can be used to pay expenses. If the price starts to decline, the premium offers a cushion (up to $750). If the price goes up, the miner will be forced to sell at $7,000 for a total gain of $400+$750=$1,150, resulting in break-even at $7,750 or 17% above the current price. Whether this is enough of a compensation will vary based on who the party is. Remember, implied volatility drives the $750 premium. Based on how high or low it is, this could mean $400 or $1,500 for example. Furthermore, the miner will be able to retain any upside from forks that happen during his holding of BTC.

Looking at the chart above (the right one), clearly the two main risks are 1/ BTC rallies massively during the term of the option and 2/ it falls by a lot. In the first case, upside for the call seller is limited and there is an opportunity cost. In the second case, the premium provides some cushion on the downside, but it may not be enough. The bottom-line is that the seller needs to be adequately compensated for those risks.

LedgerX Savings: an example of a call selling product

LedgerX offers investors to write covered calls on their Bitcoin and collect premium. Without access to their data, it is impossible to assess the current offerings. However, they show a few screenshots on the website, which I will use to guess some of the terms.

This is a screenshot from the website, dated 30 May 2018.

What does that imply? On 30 May 2018:

1. The spot price of BTC was ca. $7,400 (coinmarketcap)
2. 2x strike means $14,800 (out-of-the-money)
3. Term: 12 months
4. Offered annualized return of 16% (let’s assume net of fees), meaning ca. $1,200 USD call option premium ($7,400*16%)

In simple terms, the above means that as a BTC holder at $7,400, you get paid $1,200 per BTC today and, in return, you commit to sell your BTC at $14,800 in 12 months if the price goes above that. You keep the $1,200 in any case.

From here, we can use these inputs to solve for the implied vol — ca. 92%

Looking at the 12-mo historical vol for Bitcoin of 90% on that date, it turns out the premium incorporated in the call option is 2% vol (or 2 vol points). This seems low and comparable to traditional stock volatility. If the vol premium is high enough, vol traders tend to arbitrage it away.

Now the question is — is this vol premium adequate for Bitcoin?

An implied vol of 92% means that a call buyer expects BTC to return to its higher vol levels before 2014/15. Put differently, 92% implies that BTC would move by +/- 4.8% per day on average for 2/3 of the 365 trading days in a year. We all know BTC can be that volatile — the question is about the probability, because, as I have mentioned before, implied vol will converge with realized vol over time.

In the above case, the call seller would bet that vol has increased sufficiently and would fall to the 2015–2016 levels. As we can see on the above chart, with the benefit of hindsight, 4 months into the trade, realized vol has stayed relatively stable since May, which is good for the call seller as the time value of the option is declining (all else equal, the subsequent drop in the BTC price would have a larger negative effect on the call price).

Finally, after looking at why investors would buy calls/puts and sell calls, the last remaining basic strategy is to sell put options.

Get paid to wait

In short, when you sell a put option, you are obliged to buy the asset at the strike price at a future date, should the put buyer decide to exercise their right. For this commitment, the put seller receives a premium upfront.

Let’s start off by looking at the payoff. The picture on the left shows the result of selling puts “naked”, compared to holding the asset. Naked simply means that the investor does not hold the underlying asset. The seller has a limited upside (capped by the premium) and all the downside, similar to owning the asset (albeit at a lower price).

Why would anyone want to do that? A BTC put seller could be willing to buy BTC or add to their position at a fixed lower price where they feel comfortable for whatever reason. You can view this as a limit order on an exchange which can’t be canceled, but you get paid for it.

Put selling is not for everyone. If the price tanks, this is a bad strategy. If the price rallies, you are better off owning the asset. Put selling could be sensible if a trader/investor believes BTC has fallen enough and is likely not going to go down much more. In such cases, volatility is also likely to be high, making selling options attractive. She is then willing to add to the position if the price indeed decreases further, and also keeps the premium.

To be continued…

Hopefully, I managed to show the power of using options in the context of crypto and the vast opportunities they can unlock. In the next parts, I will discuss more strategies with options and other aspects of applying them in crypto.

OBLIGATORY DISCLAIMER: This analysis is for illustrative purposes only and does not constitute a recommendation for buying or selling of crypto (or anything else for that matter).