Sygnum Market View – 30 January 2021
Reminder: what are options
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (in our case BTC or ETH) at a specific price on a certain date. An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.
For most casual investors, that definition may as well be written in ancient Greek. Perhaps we can explain options a bit more clearly.
There are only two kinds of options: “put” options and “call” options. You’re likely to hear these referred to as “puts” and “calls.” One option contract controls 1 BTC or 1 ETH, but you can buy or sell as many contracts as you want.
When you buy a call option, you’re buying the right to purchase from the seller of that option 1 BTC at a predetermined price, which is called the “strike price.” To purchase a call option, you pay the seller of the call a fee, known as a “premium.” When you hold a call option, you hope the market price of BTC will increase in the near future. Why? If the BTC price increases enough to exceed the strike price, you can exercise your call and buy that BTC from the call’s seller at the strike price, or in other words, at a price below the current market value. Then you can either keep the BTC (which you obtained at a bargain price) or sell it for a profit. But what happens if the BTC price goes down, rather than up? You let the call option expire and your loss is limited to the cost of the premium.
When you buy a put option, you’re buying the right to force the person who sells you the put to purchase 1 BTC from you at the strike price. When you hold put options, you want the BTC price to drop below the strike price. If it does, the seller of the put will have to buy shares from you at the strike price, which will be higher than the market price. Because you can force the seller of the option to buy your shares at a price above market value, the put option is like an insurance policy against your BTCs losing too much value. If the market price instead goes up rather than down, your shares will have increased in value and you can simply let the option expire because all you’ll lose is the cost of the premium you paid for the put.
So far we have only talked about the buyer of an option. So what about the seller? Option sellers, also known as writers, sell call options with the hope that they become worthless at the expiry date. They make money by pocketing the premiums (price) paid to them. Their profit will be reduced, or may even result in a net loss if the option buyer exercises their option profitably when the underlying security price rises above (calls) or falls below (puts) the option strike price.
Options price factors
Knowing what an option is, let’s look at the factors that form the options price. There are seven of them:
1. Type of option
This is probably the easiest factor to understand. An option is either a put or a call, and the value of the option will change accordingly.
2. Underlying Price
As we have learned before, the higher the underlying price, the more valuable a call option becomes and the lower the underlying price, the more valuable a put option becomes.
3. Strike Price
Strike price follows along the same lines as underlying price. A call option with a lower strike gives the right to buy the underlying at a lower price and thus has a higher value. For put options, the opposite applies: the higher the strike, the more valuable the option. When we classify strikes, we do it as in-the-money, at-the-money or out-of-the-money. When a call option is in-the-money, it means the underlying price is higher than the strike price. When a call is out-of-the-money, the underlying price is less than the strike price.
On the flip side of that coin, a put option is in-the-money when the underlying price is less than the strike price. A put option is out-of-the-money when the underlying price is higher than the strike price.
4. Time to expiration
Options have a limited lifespan thus their value is affected by the passing of time. As the expiry date comes closer the value of the option begins to decrease. The value begins to rapidly decrease within the last thirty days of an option's life. Why is that? The more time an option has till expiration, the more time the underlying has to move around and the option to become a profitable investment. Hence, the further away the expiration, the higher the potential and thus the value of the option.
5. Implied Volatility
Implied Volatility, or IV is the only estimated factor in this model.
IV shows the "implied" future volatility of the underlying. It tells you how strongly the market thinks the underlying will move but it doesn’t tell you anything about the expected direction. Options with a higher implied volatility have a higher valuation as the potential movements of the underlying (and thus the potential to close the trade profitably) are higher if the underlying experiences more volatility.
Not necessarily relevant for digital assets here’s the theory if you’re interested:
Options do not receive dividends, so their value fluctuates when dividends are released. When a company releases dividends, they have an ex-dividend date. If you own the stock on that date, you will be awarded the dividend. Also on this date, the value of the stock will decrease by the amount of dividend. As dividends increase a put option's value also increases and a calls' value decreases.
7. Interest Rates
Interest rates have a minimal effect on an option's value. When interest rates rise a call option's value will also rise, and a put option's value will fall. The reasoning behind is slightly more complex so in the interest of the reading experience, we’ll leave it to you to read more about it here.
Popular strategies in the current market environment
In all but the latter case we assume that you are by now familiar with the basics such that we can move to showing you two strategies that clients implement in the current market environment:
A short strangle is an options strategy consisting of a sold put at strike price A and a sold call at strike price B. You are predicting the underlying price will remain somewhere between strike A and strike B, and the options you sell will expire worthless.
Traders often use short strangles if they expect decreasing volatility and a sideways moving market. If at expiry, the underlying price sits between A and B, both options expire worthless and the full premium goes to the trader. Decreasing volatility will lead to decreasing option prices (see point 5 above) and thus further boost returns. But that comes at a cost. You have unlimited risk on the upside and substantial downside risk.
A collar consists of a purchased put at strike price A and a sold call at strike price B.
Many traders will run a collar when they’ve seen a nice run-up on the underlying price, and they want to protect their unrealized profits against a downturn.
Some traders will try to sell the call with enough premium to pay for the put entirely. If established for net-zero cost, it is often referred to as a “zero-cost collar.” It may even be established for a net credit, if the call with strike price B is worth more than the put with strike price A.
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