Many people who are new to cryptocurrency options are overwhelmed by the option quote list. In this series of articles, I will try to answer the question of how to long options to newcomers who do not know the ABC of options.
To minimise the possibility of information overload, this article will focus on the discussion of call options. Subsequent articles will elaborate on put options. After reading this article, you may continue to read articles about put options. After that, you will be able to comprehend relevant topics and phenomena by analogy.
Contents
1. Preparatory knowledge
2. Understanding the option quote list
3. Profits or losses upon expiry of options
4. A trilogy for realising a profit for out of the money (OTM) options upon expiry
5. A comparison of the advantages and disadvantages of buying options and contracts
1. Preparatory knowledge
First of all, it is important to understand the name of the options contract.
Take BTC-26MAR21–56000-C for example. The meaning of each part of this contract is:
• BTC: It obviously means this is a BTC option.
• 26MAR21: This means the expiry date of the option is 26 March 2021.
• 56000: The strike price of the option is $56000.
• C: It is the English abbreviation for Call, meaning a call option. In the case of P, it is an abbreviation for Put, a put option.
It is also important to have a basic concept of what at the money (ATM) options, out of the money (OTM) options, and in the money (ITM) options are.
As shown in the T-shaped quote list in Screenshot 1, the BTC spot index price is $51,054.
The “Synthetic Futures Price” at the top of the option quote list is $53,350. The value of Deribit’s bitcoin options is calculated on the basis of futures prices.
The left side of the T-shaped quote list is about call options and the right side of the T-shaped quote list is about put options. This article will focus on call options.
For call options, the distinction of ITM, ATM, and OTM options is as follows:
• Those with strike prices between 0 and $53,350 are ITM calls.
• Those with strike prices around $53,350 are ATM calls.
• Those with strike prices being or higher than $53,350 are OTM calls.
There is an intuitive understanding of an OTM option: it is unlikely for the underlying security to reach the strike price upon expiry of the option, making a profit highly impossible. In comparison, the strike price of an ITM option has already been surpassed by the current spot price, making a profit highly likely.
On the Greeks.Live Web version page, the bottom colour of the quote list of ITM options has been fogged in green to facilitate visual identification (see Screenshot 1 below).
2. Understanding the option quote list
Again, let’s look at Screenshot 1. The dates at the top of the option quote list, such as 5 MAR 2021, 12 MAR 2021, 26 MAR 2021, and 30 APR 2021, are the expiry dates of the options (the part marked by red number 1 in Screenshot 1).
The strike price filter box (the part marked by red number 2 in Screenshot 1) reduces distractions by focusing your attention on the section of strike prices that you are interested in amidst the long option quote list.
The left side of the T-shaped quote list shows the quotes of call options and the right side shows the quotes of put options.
In the Greeks.Live web version http://www.greeks.live/web/, due to the large amount of information in the columns of the options quote list, it is not possible to display all the information in the natural screen. You can scroll down to the bottom of the quote list where there are left and right scroll bar. Click and drag the scroll bar to the right to see the complete information of put option quotes.
The middle of the quote list displays the strike prices (the part marked by red number 3 in Screenshot 1), and there are both call and put options at the same strike price.
Focusing on call options on the left, we start from “Mark Price” in the middle and then gradually shift our attention to the left and right respectively (the part marked by red number 4 in Screenshot 1).
• “Mark Price”: The purpose is to provide a mark-to-market valuation of a trader’s existing positions so that the exchange can calculate the trader’s profit/loss, net worth and margin adequacy. Although there are many detailed rules, the “mark price” is roughly based on the average of the “best bid” and the “best ask”. The white number at the top is the mark price of a BTC denominated premium, and the grey percentage at the bottom is the implied volatility (IV) of that premium.
Expansion to the left from the “Mark Price”
• “Best Bid”: It is the highest bid in the option quote list. The green number above is the BTC-denominated bid of the premium, and the grey dollar sign below is the dollar value corresponding to this bid. Those of you who are careful can see that this dollar value is calculated using the (synthetic) futures price.
• One column to the left is “Best Bid IV”: IV is the abbreviation for Implied Volatility, the term most commonly used by options traders to measure the value of options with different strike prices and different expiry dates.
• The next column on the left is “Order Size”: due to space limitations in the quote list, this column actually refers to the number of orders for “best bid”. A best bid with a strike price of 40,000 and an order size of 11.5 means that there are 11.5 BTC option orders in the best bid position. The profit or loss of 1 BTC option upon expiry and crossing the strike price is the same as that of a BTC spot (i.e., 1 BTC option corresponds to 1 BTC).
• The leftmost column is “Last strike price”: It is the latest traded premium price in BTC on that strike price.
Expansion to the right from the “Mark Price”
• “Best Ask”: the lowest ask in the option quote list. The red number above is the BTC-denominated ask for the premium, and the grey dollar sign below is the dollar value corresponding to this ask.
• “Best Ask IV”: It refers to the IV derived backward from the BTC price of the best ask premium based on the BSM formula and the (synthetic) futures price.
• “Order Size”: the number of orders for “best ask”, with the profit/loss of 1 option equivalent to 1 spot if the option is in the money upon expiry.
• “Trading Volume”: It indicates how many options have been traded since the last 4pm UTC+8. The higher the trading volume, the better the strike price, the better the liquidity, and the more active the trading. Generally speaking, trading volume is higher for ATM and OTM options and lower for ITM options. Besides, the more in-depth the ITM options, the lower the trading volume.
• “Open interest (OI)”: It refers to the size of positions held by option traders in the whole market at this strike price. A strike price with a large OI is likely to be more actively traded. For ITM options, a strike price with a large OI offering a slightly more aggressive ask is more likely to be traded.
• “Delta”: A Delta of 1 means that the profit or loss is equal to 1 BTC spot. For ATM options expiring in 1 month, the Delta is a little over 0.5. The Delta of OTM options will become smaller and smaller, eventually close to 0, whereas the Delta of ITM options will become bigger and bigger, eventually close to 1. Please note that since bitcoin options on the Deribit exchange are USD denominated and bitcoin settled, the Delta here only represents the USD denominated gain/loss in Delta. When you pay, say $56,000 BTC, for a call option, and the best ask is 0.1185 BTC, you lose 0.1185 of the spot’s Delta while gaining 0.51 of the option’s Delta, giving you a net Delta of 0.51–0.1185 = 0.3915 on a cryptocurrency basis. This might be difficult to understand. But never mind. Just remember it for the moment. Take your time to understand it later.
• “Positions”: The positions in your own account at this strike price, as shown in Screenshot 2 below. The number above refers to the number of options held at that strike price, with green indicating long positions and red indicating short positions. The percentage inside the lower brackets below is the profit/loss ratio calculated as the current option mark price to the average price at which you bought or sold the options.
- “Time left to expiry” (the part marked by red number 5 in Screenshot 1). 126d 17h 28m means that there are 126 days 17 hours 28 minutes left to expiry. Those with only 1–2 months to expiry are called front-month options contracts; those with longer days to expiry are called back-month contracts.
- The base colour of the “mark price” (the part marked by red number 6 in Screenshot 1) sometimes appears blue and sometimes red.
- A blue colour means that the best ask is below the mark price. If multiple strike prices are blue at the same time, this indicates that the quote level of the market is moving down and IV is falling. This occurs when the market is quiet or when there is a need for option sellers to roll their positions upon expiry of a large number of options on Friday.
- A red colour means that the best bid is above the mark price. If multiple strike prices are red at the same time, this is generally when there is a major swing in the market and the IV of the options market is increasing.
3. Profits or losses upon expiry of options
Let’s return to Screenshot 1. Observe the call options expiring on 26 MAR 2021.
Let’s pick the Call with a strike price of $60,000 and buy 18 options at the Best Ask of 0.0945 BTC (There are 24 options at the Best Ask. So, the market depth is enough to provide the 18 options I intend to buy).
Well, the next question is how my profit/loss and the profit/loss of these positions will change.
Due to the existence of the Mark Price mechanism, there is real-time valuation of traders’ option positions, which is known as intraday P&L. To understand its essence, you need to learn the various values-at-risk of options. There are already extensive courses on this topic in “Deribit Options Course”. So, I will not go into details here. For newcomers, understanding and mastering the profit/loss of options upon expiry is sufficient to meet the demands of trend trading.
Okay, now I have bought BTC-26MAR21–60000-C. If the bitcoin price is below $60,000 by March 26th, then this option will return to zero. The initial investment of a total of 0.0945 x 18 = 1.7010 BTC of premium calculated on the basis of 0.0945 BTC per contract will be completely lost.
If the price of Bitcoin is $63,000 at expiry, then how much money will be made? Let’s set aside the premium paid at the time of buying the option and look at the gross profit first, regardless of the net profit.
Each option will earn $63,000 — $60,000 = $3,000.
But the exchange will settle with you in bitcoin. So, $3000 is equal to $3000/$63000 = 0.0476 BTC.
For each option, there is also a gross profit of 0.0476 BTC. After deducting the cost back then, you will still suffer a loss.
Let’s assume you’re calm and don’t mind how many bitcoins you put in back then and how many bitcoins you need to get to offset the cost. Instead, you only care about having in your account bitcoins equivalent to the amount of dollars you put in back then. Then, how much (dollar denominated) should the price of Bitcoin upon expiry of your positions be to break even?
The premium invested back then was 0.0945 BTC each x $53,350.93 = $5,041.66. (The futures price was used because these bitcoins were hedged against the 26 MAR futures and would have received $5,041.66 upon expiry as well. This is your opportunity cost.)
Then when the price of bitcoin reaches $65,041.66 or above upon expiry of your positions, the profit/loss is even in USD terms.
In bitcoin terms, $65,041.66 is not enough. Instead, the price needs to go up to $60,000 / (1–0.0945) = $66,261 to break even. In practice, you don’t have to do such complicated calculations. You can just mentally multiply $60,000 by the approximate number of the premium, which is about 10%, and roughly estimate that the price needs to be 10% higher than the strike price for the positions to break even in bitcoin terms.
Many of you may ask what is required for settlement upon expiry. Delivery upon expiry on Deribit is settled with a difference, which means that the buyer and seller of the option swap the cash flow of the in-value portion if the option is exercised. The whole process is automatic and does not require the trader to do anything.
4. A trilogy for realising a profit for out of the money (OTM) options upon expiry
Still, let’s take BTC-26MAR21–60000-C for example. Let’s look at the elements in Screenshot 1.
- Bitcoin spot index price is $51,054.
- Futures price is $53,350.
- Strike price is $60,000.
- Bitcoin-based break-even point is $66,261.
Ultimately it would take an increase of approximately 29.78% from the spot price above the break-even point for this OTM call option to earn more bitcoins for the trader. Due to the limited supply of Bitcoins in total, it is destined that any strategy to earn Bitcoins is an attempt to get reward at a risk.
This 29.78% increase can be broken down into three components.
(1) Catching up with the futures contango: increase from spot price of $51,054 to futures price of $53,350, an increase of 4.49% and a multiple of 1.0449.
(2) Futures price catching up with the strike price: increase from the futures price of $53,350 to the strike price of $60,000, an increase of 12.46% and a multiple of 1.1246.
(3) The strike price catching up with the break-even point: increase from $60,000 to $66,261, an increase of 10.43% and a multiple of 1.1043.
Take these three multiples and multiply them together and finally subtract 1 to arrive at an increase of exactly 29.78%.
So, for an OTM call option to be profitable, three conditions need to be overcome: futures contango, distance of futures price from the strike price, and thickness of the premium.
The higher the market price, the more generous the contango and the premium, the more demanding the conditions.
5. A comparison of the advantages and disadvantages of buying options and contracts
Advantages of the contract
- High liquidity and ease of taking and closing positions.
- Leverage can be very high.
- It is possible to initiate liquidation to stop loss.
Disadvantages of the contract.
- Stop-loss orders may fail.
- Traders may be tempted by the market to not place stop-loss orders.
- Substantial swings may knock positions out of the market, causing the trader to fail to catch up with the original trend.
- In a highly booming market, the perpetual funding rates are extremely expensive.
Advantages of buying options.
- The front-month leverage is very high. Take BTC-26MAR21–60000-C with a premium of 0.0945 BTC for example. The leverage is 1/0.0945 = 10.58x.
- Leverage is dynamic. When bitcoin price drops, the premium decreases to a maximum of zero, and the leverage is magnified at this moment. When market swing stops, the options positions bought before are intact and will continue to function. When you identify a trend, a short-lived reverse trend cannot force option buyers back (unless you can’t withstand the trend and close your own positions midway, which is a different story).
- The maximum loss is certain. It will not exceed the initial premium invested.
- Total premiums of back-month options are satisfactory. For example, there are currently June options with 4 months to expiry with an ATM premium of approximately 22% and September options with 7 months to expiry with an ATM premium of 25%. There is also a December option with 10 months to expiry with an ATM premium of approximately 35%. At the perpetual funding rate of 4–5% in the last month, these premiums are considerably lower than the perpetual funding rates, and there is no risk of liquidation.
- A perfect balance of leverage and winning percentage at your fingertips with the freedom to adjust the proportions of OTM and ITM options and the proportions of front-month and back-month options. The higher the leverage, the lower the winning percentage; the lower the leverage, the higher the winning percentage. Everyone has different preferences as to which point is the most appropriate. The options market offers various strike prices from which you can pick the one most suitable for you.
Disadvantages of buying options.
- Poor liquidity. Slippage in the options market is a presence to be aware of, and newcomers need time to adapt. ITM options, in particular, have extremely poor market performance. However, I have already mentioned how to reasonably close ITM options in another article.
- It becomes a counterparty to time. After buying an option, the clock keeps ticking and the time to expiry gets shorter and shorter. Yet meanwhile, the market is not moving and the time available for you to wait for a turnaround becomes less and less.
The legends/screenshots shown in this article are generated from the order page on www.greeks.live/web/. You are welcome to use the page more. Your encouragement is our motivation. We will follow up with more practical guide articles on a regular basis.
Jeff Liang
February 18, 2021
