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Options can be intimidating, so we've put together an introduction to help you get acquainted with what they are, how they're priced, and how you can use them as part of a sophisticated trading strate
Options are immensely powerful financial instruments. Buyers of options can hedge their portfolios, generate leveraged upside returns or simply cheaply get upside to a stock, all with limited downside. Sellers of options can generate high returns on their investments by selling both calls and puts, generating yield that is unmatched elsewhere in the world of finance. This is why options are a multi-trillion dollar market in traditional finance, with options traders often driving the movements of the stock market generally.
An option gives the holder the right to buy or sell a particular asset at a specified price (the strike price) for a certain period of time. There are two kinds of options, calls and puts. Calls allow the holder to lock in a price at which to buy the stock. Puts allow the holder to lock in the selling price. You buy calls when you think the stock will go up, and you buy puts when you think it’ll go down. Options don’t last forever, though, they have an expiration date. After this date, the holder can no longer buy or sell the asset at the strike price and the option is worthless.
Options can have many different strike prices, and many expiries, giving traders a variety of potential hedging solutions. Let's introduce an imaginary asset called JaguarCoin (JAG), that promises to fund jaguar conservation by using DAO funds to flip used Jaguar cars.
If JAG coin is trading at $100, it may have options available which expire at the end of January, February and March, for strikes ranging from $50 to $150. The further away from the current price a strike is, the more expensive or cheaper options get, depending on whether they are ‘in the money’ or ‘out of the money’.
Traders talk about options in three groups, ‘in the money’ (ITM), ‘at the money’ (ATM), and ‘out of the money’ (OTM).
In the money: options which currently give you the right to trade the asset at a better price than the current price.
- For calls, it’s options with strikes that are lower than the asset price. (e.g. the JAG $80 call, if JAG is trading at $100)
- For puts, it’s options with strikes that are higher than the asset price (e.g. the JAG $120 put, if JAG is trading at $100)
Out of the money: options which currently give you the right to trade the asset at a worse price than the current price.
- For calls, it’s options with strikes that are higher than the asset price. (e.g. the JAG $120 call, if JAG is trading at $100)
- For puts, it’s options with strikes that are lower than the asset price (e.g. the JAG $80 put, if JAG is trading at $100)
At the money: options with a strike price which is equal or close to the asset price. This often includes very slightly ITM and OTM options, since it’s rare for an asset to exactly equal a strike. For example the $100 strike if JAG is trading at $100.
Continuing the JAG token example from the previous section (trades at $100) we introduce the concept of a payoff graph. Payoff graphs are a great instrument to help gain an intuitive feel for options. We'll first example the payoff graphs that represent the potential profit or loss (P/L) for vanilla long/short asset positions. For example, if you are long an asset (such as ETH), the P/L graph is as follows:
You can see that your risk is proportional to how many tokens you buy. Buying 5 JAG tokens will mean that you make or lose $5 for every one dollar move in the token price. The maximum gain from being long a token is potentially unlimited, the maximum loss is the amount you purchase the token for.
Instead of buying first, and selling later, you can sell first and hope to buy back the token at a lower price, this is known as short selling (or shorting). The payoff graph for shorting is as follows:
The maximum gain for a short token position is the amount you sell the token for. The maximum loss is unlimited, as the price of a token can rise forever. Note that these payoffs are the inverse of a long token position. For example, Alice can borrow JAG tokens for $100, and sell it in the market. If the price falls to $90, Alice can buy it back, return the tokens to the person she borrowed them from whilst banking $10 in profit.
The three biggest factors that determine the price of an option are:
- Price - the token price relative to the strike price
- Time - the amount of time remaining until expiration
- Implied Volatility - how much the token is expected to move until expiration
If an option is in the money, then it is said to have intrinsic value. For example, the $80 strike call for an asset worth $100 can be immediately exercised to realize a $20 gain. When you buy this call, the $20 intrinsic value is baked into the price of the option (you don’t get it for free).
The more time to expiry, the more time there is for the token to move and the more expensive the option is. The price of an option is strictly increasing with respect to time.
The implied volatility (IV) of an asset expresses how much the asset is expected to move until expiration as a percentage. The higher the IV of an asset, the more it is expected to move, and the more expensive options are. Similarly, if IV is low, options will be cheaper. Since the price of an asset and the time to expiry are publicly available inputs, the IV of the asset is the biggest driver of pricing differences between options traders. Volatility is described in more detail in the next section.
Volatility is a measure of how much something moves. When traders discuss volatility, they’re referring to one of:
- The price swings of an asset (market volatility)
- The implied volatility of options (IV)
The market volatility of an asset is a result of the observed day to day swings in price. This is volatility that is in the past, and is why we say things like ‘crypto is a volatile asset class’ and ‘bonds are stable, safe yielding assets’. This is referred to as ‘historical’ or ‘realized’ volatility.
With assets, historical volatility is a measure of how much the price changes over a given period of time. If an asset is expected to move 2% per day, and instead moves 10%, it would be referred to as having realized ‘high volatility’. Similarly, if an asset normally moves 5% per day, and only moves 2%, it would be realizing ‘low volatility’.
On the other hand, implied volatility is the market’s expectation of how much an asset will move, and is reflected in the price of options expiring in the future. This is effectively an estimate - the market can guess that an asset will move 10% over the next month, but it might move 50% (or not at all). An option with an implied volatility of 50% is saying that the underlying asset is expected to trade within a 50% range (high to low) within the next year.
Continuing our example of a JAG token which trades at $100 and has an IV of 50%. Options markets are therefore implying that JAG could move up or down 50% over the next year, creating an expected range of $50-$150. A good rule of thumb is to take the IV of an asset and divide by 20 to attain the average expected daily move. For example JAG (50% IV) is expected to move 50/20 = 2.5% per day. This means an asset with 20% IV is expected to move 1% per day, and an asset with 100% IV is expected to move 5% per day.