What is an Option?

IntermediateDec 14, 2022
Gain exposure to price variations with limited downside or hedge against crashes
What is an Option?

Introduction

An Option is a derivative product that gives investors the right to choose if they want to trade a specific asset at a given price on a particular date.

To make it simple: it means that you could buy an Option today that offers you the possibility of purchasing an asset - for example, Bitcoin (BTC) - on a future date at a given price - $20,000 in 60 days.

Suppose the price of BTC is $20,000, and 60 days later, it goes to $40,000. Now, the option you bought will be a great deal for you. While everybody in the market needs $40,000 to buy 1 BTC, you acquired the right to buy it at $20,000 two months ago. On the other hand, if the BTC price went to $10,000, your option would basically be worthless since you can buy it cheaper on the spot market.

What is an Option?

Crypto options work similarly to stock options. So let’s go deeper into the concepts behind this derivative product.

There are two main characters in an Option operation: the buyer and the seller. The buyer will pay a value, called “premium”, to obtain the trading right of an underwriting asset at a specific time and price. He has the right - not the obligation - to execute the trade at the conditions he bought.

On the other side, there is the seller. The seller, as the writer of the agreement, receives money for giving it to the counterpart but now has an obligation to perform what is specified in their Option agreement - as long as the buyer requests to exercise his power.

Sellers are usually professional investment institutions with careful risk management strategies and a hedging method that allows them to take more risks. Since this is a more treacherous operation, Gate.io temporarily does not allow ordinary users to sell (also known as write) options. That is, users can only buy and reduce positions.

Types of options

Call and Put options

Options are divided into calls and puts based on their rights and obligations.

  • Call options give the right to buy.
    • If you buy a BTC Call Option, you have the right to buy it at a specific price.
    • If you are the option seller, you have an obligation to buy it.
  • Put options give the right to sell.
    • If you buy a BTC Put Option, you have the right to sell it at a particular price.
    • If you are the option seller, you are obligated to sell it.

ITM, ATM, and OTM options

According to the relationship between the strike price and the underlying asset’s price, options can be classified as:

  • in-the-money (ITM):
    • ITM in a Call option: when the strike price is less than the current spot price of the underlying asset;
    • ITM in a Put option: when the strike price is more than the current spot price;
  • at-the-money (ATM): when the strike price is equal to the current spot price;
  • out-of-the-money (OTM):
    • OTM in a Call option: when the strike price is more than the current spot price;
    • OTM in a Put option: when the strike price is less than the current spot price of the underlying asset.

European and American Options

According to the exercise time, they are divided into European and American:

  • European options can only be exercised on their settlement date;
  • American options can be exercised any time during their validity;

Currently, Gate.io’s short-term options are European-style options - they cannot be exercised in advance.

To whom are the Option products recommended?

Options are traded based on investors’ expectations of the future prices of the underlying assets. If they buy call options, they assume the prices will go up until the settlement date. If they buy put options, they assume the prices will go down until the settlement date - which is often used as a hedge in their portfolio.

The option prices constantly vary until the exercise date for several factors, but keep in mind that they fluctuate primarily due to the current price of the underlying asset and the time left until the exercise date.

Options are usually recommended for more experienced traders that already understand how the derivatives market works, and also for those who intend to hedge their assets against a drawdown in the market.

Advantages of trading with options on Gate.io:

  • Built-in leverage function: use limited funds to gain unlimited income;
  • Risk is controllable: the maximum loss is the premium, and there is no risk of liquidation;
  • Flexible operation methods: combine multiple portfolio strategies to hedge risks

It’s important to mention that the structure is complex and might be challenging to understand for non-professional traders. It requires complete investment knowledge and a full understanding of potential risks before trading.

How to trade options on Gate.io?

Go to the Options product page on Gate.io to see the available options based on the cryptocurrency, expiry date, and strike price.

The platform provides the current Spot Index price and the days until exercise to give users more accuracy when trading. It also provides indicators such as IV, leverage, delta, and other greeks - indicators that represent the sensitivity of the options contract price.

After you select the desired option to invest, input the price and size of your order and click on the direction of your operation: buy (long) or sell (short). Since the price fluctuation is higher than in Spot Trading, it’s recommended to keep an eye on the value of your assets.

Conclusion

Options are advanced products that allow traders to gain exposure (usually leveraged) to a potential token price variation and have a limited downside.

It can be profitable for traders if their expectations of the market directions are confirmed and can be used for hedging strategies in more advanced portfolios. Although the possibility of earning high profits usually attracts most users into trading Options, we strongly advise doing your own research and having a deeper understanding of how this product works and what determines its price fluctuations before investing in it.

Options are products recommended for more experienced traders, with some background in derivatives and risk management strategies in the traditional market. Once you understand the power of strategies using Options, you can see how handful it can be for mitigating high volatility risks during uncertain times in crypto.

Author: Gabriel
Translator: shining
Reviewer(s): Mauro, Hugo, Joyce
* The information is not intended to be and does not constitute financial advice or any other recommendation of any sort offered or endorsed by Gate.io.
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