How to Long Options PART 3 || Options Guide
Previously, I was asked how to long options. This question caught me by surprise. Later, I gave it a second thought and felt there’s a reason for that. So, I wrote this “How to Long Options” series.
In How to Long Options (PART 1), I introduced how to read the T-shaped quote list.
In How to Long Options (PART 2), I introduced how to operate the options order page and optimize slippage.
In this article, I will further analyse the leverages and “success rates” of options with different degrees of value.
PART 3 Contents
8. Avoid buying deep in the money (ITM) options
9. Characteristics of out of the money (OTM) options
10. A comparison of the leverages of at the money (ATM) options with different expiration dates
8. Avoid buying deep in the money (ITM) options
The reason why it is important to avoid buying deep ITM options is because the liquidity of ITM options decreases significantly. As a call option gets deeper into the money, its Delta approaches to 1, making the option approximate a futures contract. However, unlike futures that still have quite good liquidity, ITM options are very poorly placed in the market.
From time to time, I see users inside the Exchange Group buying ITM options. Perhaps because they do not understand what an ITM option at this strike price means. They even go so far as to directly fill the counterparty’s orders. In fact, this is a big taboo. By doing so, they would lose a lot of slippages and will not enjoy the utility of the dynamic leverage of the option. Therefore, please make sure to avoid buying deep ITM options when opening positions.
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9. Characteristics of out of the money (OTM) options
The characteristics of OTM options are low premium and high leverage (1/premium).
As an option approaches expiration (an option expiring in 1–2 months is already considered an option approaching expiration), the decay in time value is drastic for the limited premium of an OTM option.
A less rigorous but useful approach is to approximate the option’s Delta as the probability of reaching the strike price at expiration, or the “success rate”. For example, if the Delta of the BTC-5MAR21–66000 Call in Screenshot 5 is 0.20, then the approximate probability of reaching the strike price of $66,000 in 10 days at expiration from the current price of more than $55,000 is 20%. And the leverage of this option is the inverse of the premium of 0.0185 or 1.85%, which is 1/0.0185 = 54x leverage. As the leverage is quite high, price decline will not end up in liquidation, and there is 20% probability that the option can be exercised.
Along these lines, I can list the premium, leverage, and Delta for each strike price as follows, and analyse what kind of leverages and success rates are available for different strike prices. See Screenshot 6.
There are some differences between the leverage of an option and the leverage of a contract. If a contract has a high leverage, its holder will start earning a profit when the price goes up slightly.
In comparison, if an option has a high leverage, its holder will also earn a profit, but the profit earned is often not enough to cover slippage. The entire trend must turn out more pronounced before there is a sizable profit for closing the position. If the market never goes up, this highly leveraged option is headed towards returning to zero. Upon expiration, basically a profit can only be earned when the price of bitcoin really exceeds the strike price. As to how high the success rate is, you can look at Screenshot 6 below to evaluate by yourselves.
Certainly, contract holders also tend to operate with 20x leverage, but the leverage of front month ATM options can actually go up to 20x very easily and with a decent success rate. This is complemented by the fact that the position will not end up in liquidation, which provides a good cushion for traders during the not-so-long period to expiration. In this way, traders will not have to worry about losing the position when the price bounces back.
10. A comparison of the leverages of at the money (ATM) options with different expiration dates
Next, I will do a comparison of the leverages of options with different days to expiration based on today’s quotes for bitcoin ATM options with different expiration dates on February 22, 2021. See Screenshot 7.
It can be seen that the leverage of an ATM option increases rapidly as it gets closer to expiration.
However, while leverage is magnified, this option has less fault tolerance of timing due to the proximity to expiration.
If the bitcoin price does not exceed the strike price and a profit equal the premium is not earned during the remaining days to expiration, then the long position would result in a loss.
Contract traders often like to add positions depending on the trend line and tend to hold positions for a short period of time, such as 1–2 days. In this case, I would recommend ATM options expiring in 1–2 days, because their leverages are already very high, such as 35x-50x, and can withstand inverse market trend in a short period of time. Therefore, their maximum loss is certain. After buying such an option, do not think about closing the position halfway, because the slippage of buying it and selling it will also be large. Wait for it to expire and hold it for a period of time to see if your judgment of buying it was accurate.
Basically, traders must be prepared to hold their positions for at least the same length of time as the number of days to expiration for options with whichever expiration dates they bought. In the cryptocurrency options market, with the current liquidity and spreads, frequent entry and exit is doomed to failure.
When a trader is longing options expiring in 1 month or more, it is perfectly fine to take his/her time and optimize his/her costs by posting IV orders. Because the trader is going after the trend in nearly a month, a 1–2-day difference in getting the order filled does not matter. In the options market, slow and steady wins the race, and a trend following mindset is crucial.
I hope this article is helpful to you.
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 22, 2021
