An option is a financial contract that grants buyers the right to buy or sell an asset at a specific price on or before a specific expiration date. An option’s target price is known as its “strike price” and its specified expiration as its “expiry.”
Accordingly, options are a type of financial derivative since they derive value from the underlying assets they track. Traders use these instruments to speculate on asset prices or hedge against risk.
For example, if you think the ETH price will exceed $5,000 USD six months from today, you could purchase an options product to lock in a directional bet and “go long.” Alternatively, if you’re worried the ETH price will crash over the next six months you could “short” ETH with an option. If such a downside bet is successful, you would profit by having hedged against the ETH price decline!
A quick guide to options
Options can be structured in a variety of different ways. For this reason, the easiest way to understand any option is to figure out its core elements, namely its type, style, and settlement method.
Calls and puts
There are two types of options: calls and puts. A call option gives an investor the right to buy an underlying asset on or before an expiry. A put option grants the right to sell an asset on or before expiry.
In either case, an option holder isn’t obligated to execute their right to buy or sell. This freedom offers traders superior flexibility and is one of the main advantages of these financial derivatives. Moreover, traders can trade options to other investors prior to expiry, a dynamic that affords even further flexibility.
American vs. European style
The two most popular option styles are American and European. Investors in American-style options can exercise their contracts any time prior to expiry, while investors in European-style options can only exercise their contracts after expiry.
Cash-settled vs. Physically-settled
Companies and decentralized protocols can settle options via cash settlement or physical settlement.
At expiry, a cash-settled option pays out its cash value to investors via an equivalent sum of USD, BTC, ETH, etc. In contrast, a physically-settled option must pay out via the actual delivery of that option’s underlying asset. For example, a physically-settled ETH option would have to pay out with a delivery of ETH.
ITM and OTM
An option is in the money (ITM) or out of the money (OTM) depending on where its underlying asset’s price is in relation to its strike price.
In other words a call option is ITM if its underlying asset’s price is higher than the strike price, and a put option is ITM if its asset’s price is lower than the strike price. Conversely, a call is OTM if its asset’s price is lower than the strike price, and a put is OTM if its asset’s price is higher than the strike price.
As such, options pay out at expiry depending on whether they’re ITM or not. Options that are ITM prior to expiry trade at a premium since they have a higher probability of reaching expiry ITM.
Trading options on crypto exchanges
In recent years savvy traders have flocked to options markets on centralized cryptocurrency exchanges, i.e. trading venues run by for-profit companies rather than decentralized blockchain-based protocols. During this time, a handful of these exchanges have become go-to destinations for options traders in the cryptoeconomy. Some of the most popular are as follows!
Top crypto options exchanges
- Deribit — cash-settled, European-style options market for BTC, ETH
- LedgerX — physically-settled, European-style options market for BTC, ETH
- OKEx — physically-settled, European-style options market for BTC, ETH
- CME — cash-settled, European-style options market for BTC
- FTX — cash-settled, European style options market for BTC
DeFi crypto options
Popularized on Ethereum, DeFi options protocols use smart contracts to provide and settle options. This decentralized design allows options to be settled on-chain 24/7 in efficient and transparent fashion. Additional advantages of DeFi-based options stem from these instruments being:
- Non-custodial: users stay in control of their own funds at all times.
- Permissionless: users only need an Ethereum address to interact with the options, no account registration or KYC required.
- Yield-generating: with projects that rely on liquidity pools around their options depositors can earn trading fees for providing liquidity.
Accordingly, DeFi options projects offer a series of crypto-native benefits that traditional crypto options exchanges can’t match. A handful of notable options protocols to watch include the following.
Opyn is a decentralized options protocol for cash-settled, European-style options. The project’s V1 system pioneered DeFi options and required these tokens be fully collateralized with user deposits. Opyn recently released its V2 system, which allows traders to enjoy partially-collateralized options.
Hegic is a decentralized options protocol for cash-settled, American-style options. The project centers around a liquidity pool system in which liquidity providers (LPs) serve as option writers for buyers.
UMA is a decentralized protocol for creating synthetic assets, like synthetic options, on Ethereum. For example, earlier this year the builders of UMA unveiled how to use their infrastructure to create cash-settled, European-style options for any Ethereum-based token.
Ribbon Finance is a decentralized protocol for creating crypto structured products. Ribbon Finance’s earliest products have been vaults that earn depositors yields via automated options selling strategies. So far these vaults have mainly relied on covered calls and put selling strategies.
Do you want to see a complete list of Crypto Options Protocols? Check our DeFi List and scroll until the “Options” section!
Risks of crypto options
When it comes to trading crypto options you can never eliminate market risk. This kind of risk factor comes from things that can affect the entire crypto market at once, like the breakout of a global economic recession. Options traders also face price risk, e.g. if their trade ends up OTM at expiry.
As for DeFi options protocols, users of these projects face the possibility of smart contract risk, like a code flaw being discovered and attacked by a hacker. There’s also regulatory risk, for example a protocol’s liquidity drying up after being deemed an unregistered securities exchange by a government watchdog.