What an option is
An option is a contract that gives its buyer a right, but not an obligation, to trade an asset at a set price. Options on bitcoin and ether trade on several crypto and regulated venues. The idea comes from traditional finance, and the terminology is the same.
Options are more complex than spot buying, and sellers of options can face large losses. This article covers the vocabulary and the logic only, and it is not advice.
Key terms
- Call. A call gives the buyer the right to buy the asset at the strike price. Buyers generally want the price to rise.
- Put. A put gives the buyer the right to sell at the strike price. Buyers generally want the price to fall, or want protection against a fall.
- Strike price. The agreed price at which the right can be used.
- Expiry. The date the option ends. After it, the option is worthless if not in the money.
- Premium. The price paid by the buyer to the seller for the option.
- Exercise and settlement. Using the right. Many crypto options are cash-settled, so the holder receives the difference in value instead of coins.
- Buyer and seller (writer). The buyer pays premium and has limited loss. The seller receives premium and takes on the obligation.
- Moneyness. An option is “in the money” if using it would have value, “at the money” if the strike is near the current price, and “out of the money” if it would not have value now.
A worked call example
These numbers are made up for illustration. Say a coin trades at $60,000. A call with a $60,000 strike expiring in a month costs a premium of $2,000.
- If the price at expiry is $55,000, the call is worthless. The buyer loses the $2,000 premium and nothing more.
- If the price at expiry is $62,000, the call is worth $62,000 − $60,000 = $2,000, which equals the premium. The buyer breaks even, ignoring fees.
- If the price at expiry is $66,000, the call is worth $6,000. After paying $2,000, the profit is $4,000.
The breakeven is the strike plus the premium: $62,000. The buyer’s maximum loss is the premium. The seller of this call keeps the $2,000 if the price stays below the strike, but loses more as the price rises above $62,000, with no ceiling on that loss in theory.
A worked put example
With the coin at $60,000, say a put with a $60,000 strike costs $1,500.
- If the price at expiry is $65,000, the put is worthless, and the buyer loses $1,500.
- If the price is $58,500, the put is worth $1,500, so the buyer breaks even (strike minus premium).
- If the price is $50,000, the put is worth $10,000, and the profit is $8,500.
A holder of the coin might buy a put as a form of insurance. The premium is a cost, and if the price does not fall, that cost is lost. This is one example of hedging, which is a risk management use of derivatives.
What implied volatility is
An option’s price depends on several things: the current price, the strike, time to expiry, interest rates, and expected price movement. Of these, expected movement is the one that cannot be observed directly. Implied volatility works backwards from the market price of options to find the level of movement that the pricing model would need in order to produce it.
It is usually quoted as an annualised percentage. A higher figure means options are more expensive because the market is pricing in larger swings. It is related to, but different from, realized volatility, which measures actual past movement.
A rough illustration
If implied volatility is 60% annualised, a common rule of thumb scales it to a shorter period by multiplying by the square root of the fraction of a year. For 30 days, that fraction is about 30/365, or roughly 0.082, and its square root is about 0.287. So 60% × 0.287 is about 17%. This is sometimes read as a typical one-standard-deviation move over that month. It is a simplification: real prices have fatter tails than the model assumes, and the figure says nothing about direction.
Why it matters, and its limits
Implied volatility tends to rise when markets are stressed or when big events are expected, and to fall in calm periods. Traders watch it to judge whether options are expensive or cheap relative to recent history, and it is often used as a gauge of market sentiment about uncertainty.
Important cautions:
- It is not a forecast of direction. A high number means large moves are expected, up or down.
- It can be wrong. Implied volatility can be above or below what actually happens, and outcomes are uncertain.
- It differs by strike and expiry. The pattern across strikes is called the skew or smile. If puts cost more than equivalent calls, that may reflect demand for downside protection.
- It depends on a model. Different assumptions give different numbers.
- Liquidity varies. Options markets can be thin away from the main strikes and expiries, and wide bid-ask spreads make prices less precise.
How options relate to other markets
Options are one part of the broader family of crypto derivatives. Sellers of options usually hedge by trading the underlying or futures, which links options to the other markets. Other derivatives, such as perpetuals, carry linear exposure, whereas options have payoffs that bend around the strike.
Risks to keep in mind
Buying options can lose the whole premium quickly, because they decay in value as expiry approaches if nothing else changes. Selling options can lead to losses much larger than the premium collected. Cryptocurrency prices are volatile, and people can lose all they invest. This material is for education and is not financial, tax or legal advice.