Options are the next battle frontier for DeFi and understanding how they work so you can be informed is going to be crucial. Like most people here I found options extremely confusing at first but eventually over time I’ve come to understand them and their power. This piece is going to be deconstructing options and how the basics work.
There’s also a video in case you’d like to watch all the below instead of reading:
If you know the basics of options, skip this part 🙂
Most instruments in DeFi are opinions expressed as numbers. An option is an option that allows you to bet on the price of an asset moving in a certain direction without going all-in. These opinions have two sides to them:
An option-seller (the person who sells the ability to exercise an opinion)
An option-buyer (the person who buys the ability to exercise an opinion)
The two opinions that can be expressed are:
Call Options – the ability to buy an asset at a certain price in the future
Put Options – the ability to sell an asset at a certain price in the future
A simple example of how you might use these instruments to express your opinion in the market:
Call buyer: I think the price of Bitcoin is going to go to $30k but I’m uncertain about purchasing it at $20k. I decide to buy 1 call-option contract that lets me purchase BTC at $20k in one month from now for $1,000. If the price of Bitcoin goes above $21k (hedge price + cost of option), then my $1,000 was well spent. If the price goes to $15k, then I take a $1,000 loss but I’m okay with it since it prevented me from losing money from buying the top. I won’t exercise my option since buying BTC for $20k doesn’t make sense when the market price is $15k.
Put buyer: I think the price of Bitcoin is going to go to $10k but I’m not confident in shorting an asset in a bull market. I decide to buy 1 put-option contract that let’s me to sell BTC at $20k in one month from now for $1,000. If the price of Bitcoin goes below $19,000 (hedge price – cost of option), then my $1,000 was well spent. If the price of Bitcoin goes to $30k, then I take a $1,000 loss but I’m okay with it since it prevented me from losing money selling the low. I won’t exercise my option since there’s no point selling BTC for $20k when the market price is $30k.
Hopefully the above two scenarios make it easy to understand the motivation of the buyer. On the other hand, understanding the motivation of the seller is a bit more complex. There’s two factors which they’re betting on: volatility and direction. We’ll break this down a bit more below.
Call seller: I think the price of Bitcoin is going to stay close to ~$20k over the next month or will drop below. Based on this opinion, I decide to write a call option for $20k that expires in one month from now. This means that I’m willing to sell BTC for $20k regardless of what the price is in a month. In some sense this is an extremely risky move since it means that I could be losing out on the massive price rally. However, if I don’t think the price is going to move much (or that it’ll go down), I can make money by selling an option for a certain amount.
Put seller: I think the price of Bitcoin is going to stay close ~$20k over the next month but I’m long term bullish and don’t mind purchasing at a higher price than the market if it dips. Based on this opinion, I decide to write a put option to sell BTC at $20k that expires in one month from now. This means that I’m willing to buy BTC for $20k regardless of what the price is in a month. The motive for put sellers is more complex since if the market dips to $15k, you’ll be forced to buy BTC at $20k resulting in a $5k loss (less premium). However if you’re a Bitcoin bull and you’re happy to buy at whatever price, the income earned from selling the option may be worth it.
Okay so hopefully the above gives you a solid understanding of all the different scenarios and why people would do certain things.
The other thing that we should probably clear up before moving on is clear terminology about all of the terms involving options.
Expiry Date: the date at which the option to buy/sell the asset at the specified price is no longer true. Options do not last forever.
Strike Price: the price at which the underlying asset can be purchased/sold when exercised at expiry.
Option premium: the amount the seller of an option gets when they write the option to a buyer. This can also be expressed as the amount that the buyer pays to get access to the option.
Intrinsic value: the value of an option based on the difference between a stock’s current market price and the option’s strike price. If a BTC call option (right to buy is $20k) and the price of BTC is $25k then the intrinsic value would be +$5k.
In the money: when the intrinsic value of an option is positive
Out of the money: when the intrinsic value of an option is negative
A few examples of how me might use or talk about the above terminology:
I’d like to write an option that expires on 25th Dec 2020 (expiry date) for BTC at $20k (strike price) for $2,000 (option premium)
Since the price of BTC is $25,000 my $20,00 12 Dec (expiry date) call option has an intrinsic value of $5,000 and is in the money.
As you can probably tell from the above, options can be an extremely powerful way to express an opinion about the market without it costing a fortune or your entire stack.
We’ll end up going into these in more detail in the next article about Greeks and pricing. For now, hopefully you understand the basics of what options are and how they work. Eventually with this body of knowledge, we can use it to better understand the options battle arena in DeFi!