Options contracts are derivatives instruments that might seem complex initially, but the basic strategies are relatively simple. Let’s picture a cryptocurrency miner, for example. His costs are steady: utilities, loan payments, rent, ASIC machines maintenance, internet provider, staff, and similar.
However, miners’ revenues are incredibly volatile, as the payout is in cryptocurrency. Sure, one can sell those at market prices and use the fiat money to pay for expenses. However, this income largely depends on the crypto market prices, and the whole operation might be compromised.
How to reduce the price volatility?
What if the miner could ‘lock in’ the price for the following months, and better yet, possibly higher than the current market level. That’s where option markets enter. Such a miner would sell a right (call option) for someone else interested in the specific price level at a future date.
Let’s see an actual example to make things more clear:
The above market screenshot shows that someone is willing to pay $6,651 upfront for the right to acquire Bitcoin (call option) at $28,000 on July 30. That option price, known as premium, is based on the current $32,687 price and will cost more as the Bitcoin price rises.
No matter if it’s trading at $20,000 or $50,000, the option buyer gets to decide if he’ll exercise this right. On the other hand, on July 30, or 37 days, the call option seller must settle the difference if Bitcoin is trading above $28,000. Then, the seller can use the $6,651 upfront received to cover eventual losses.
The call option will act as a safeguard
For the miner, it’s a win-win. On July 30, if Bitcoin trades at $20,000, the option buyer will give up the right to purchase it for $28,000. All the miner has to do is sell his Bitcoin at the market. In this case, he’ll pocket $20,000 plus the $6,651 previously paid by the option buyer.
However, if Bitcoin is trading at $50,000 on July 30, the miner will pay the $22,000 difference to the call option buyer but will keep the $6,651 upfront. Therefore, the financial result is equivalent to selling Bitcoin at $34,651. Thus, the operation limits the miner’s upside, but at the same time, provides insurance if the price goes down, reducing the loss.
What are the advantages for the call option buyer?
The call option buyer has the right to acquire Bitcoin at $28,000 on July 30. Imagine you’re extremely bullish but afraid of the volatility during the period. If you opt for buying leverage longs, using 8x leverage, for example, your position gets liquidated if Bitcoin drops 12% from your entry-level.
However, acquiring a call option gets you the right to purchase Bitcoin at a fixed price in the future, no matter the oscillations during the period. Therefore, if Bitcoin drops from the current $36,687 to $31,000 on July 30, your call option is worthless, and you lose the $6,651 upfront.
However, if Bitcoin trades at $41,000 on July 30, the call option seller must hand out the price difference to the $28,000 previously agreed, equivalent to $13,000. The net result, excluding the upfront payment, is a $6,349 profit.
In short, the call option is paying upfront for upside protection. Meanwhile, the seller is looking to reduce the downside while simultaneously giving up some of the upside.