May 17
Options trading
The appeal of options trading is the “leverage” they provide.
Since 1 option contract controls 100 shares of the underlying asset, buying a call option contract exposes the gains and losses of 100 shares at a fraction of the price of 100 shares.
In this article, we will cover option contract trading. Since you've made it to this article, I assume you already know what "option contracts" are. I skip covering what an "option contract" is because that information is available everywhere online.
For the retail traders
“call options” and “put options” for retail traders are bets on the direction of the asset price.
They purchase a “call option” if they believe the price will increase
They purchase a “put option” if they believe the price will decrease.
(Please do not do this. You will lose your money. It will gradually become a generous contribution to a hedge fund manager’s whine collection)
You have learned in school, on television, or YouTube how to visualize atoms, protons, neutrons, electrons, etc.
This model is entirely inaccurate, yet we use it because it helps us visualize the specifics of these abstract subjects.
Consider everything in this article to be an oversimplification to assist you with more advanced reading about options trading
Unfortunately (or fortunately), retail traders like you and I do not have access to leverage as institutions have. Typically, if you are trading stocks, your broker will enable you to borrow the value of your portfolio.
If you have $6,000 in your Robinhood account, the maximum amount you may borrow is $6,000. The leverage of 2x is relatively low. Thus, retail traders must find a way to maximize leverage without borrowing funds.
You may have an idea where this is heading.
Options trading.
I also want to announce I “might” start a blog to independently write articles and maybe write daily or weekly newsletters.
You can subscribe and I will most likely post there more in-depth analyses, articles, and newsletters. I write these articles mainly because it forces me to study more. Explaining subjects to others is a great way to get a deeper understanding.
Most professional traders who work for hedge funds, quantitative funds, banks, etc., use option contracts mainly for hedging.
They often use options to hedge against adverse price movements in the underlying asset, like paying a fee to transfer risk to other parties.
Let's focus on having a firm basic fundamental understanding of options trading. This article is only part 1. There will be more articles
If you've been trading options before, you might have asked yourself
Why is it that buying options took away all of my of options?
Options trading is a complicated task. Fortunately, you do not need a deep understanding of the mechanics to earn money trading them. However, if you have a solid knowledge of the fundamentals, you can consistently earn money (or lose less money so fast).
Now let's start with the basics first.
Part 2 of options trading you can find here:
Part 3 of options trading you can find here:
Buying an asset
Consider bitcoin as an example. We buy $10k worth of bitcoin at $30k. Later, the price of a bitcoin approaches $36k
In this graphic, we have the price of bitcoin on the x-axis and on the y-axis is our PNL (return on investment/profit-net loss)
I use this tool for these Deribit graphs: https://pb.deribit.com
If the price of bitcoin rises to $50k, we will earn around $5,881 in profit, which is good.
However, the price of bitcoin might decline to $10k. This price fall results in a loss of around -$5266
This 45-degree line represents the payoff. That’s is a “linear” payoff or “delta one payoff.”
If bitcoin or another asset rises, we profit. If the asset's price declines, we will suffer a loss. Our maximum loss reaches if the price falls to 0, and we will lose our total investment of $10k.
Now I mentioned the payoff is linear. There’s also something as a “non-linear” payoff, which doesn’t look like a straight line but a curve.
Shorting an asset
The derivatives market provides an opportunity to profit from falling asset prices. “Short selling” with margin trading or futures trading enables traders to sell an asset they do not own. If the price of the asset falls, the trader can buy it back at a lower price and return it to the exchange, pocketing the difference as profit.
We “shorted” $1000 worth of bitcoin at $30k. The price of bitcoin is currently $36k.
This graphic demonstrates that if the price of bitcoin declines (moving towards the left side of the x-axis), PNL (y-axis) begins to rise.
If the price of bitcoin falls towards the price of $20k, we can see in the graph below that we make a profit of around $2395
However, when short-selling, the maximum amount of money we can earn is the amount we “short-sell” because the downside of the price is limited to 0.
When buying, in theory, the maximum amount of money we can earn is infinite. Since the price could go up infinitely in theory, that’s not the case with short-selling.
In our case, our maximum profit can only be $10k, which is the amount we are "short-selling."
In our case, we sold at $30k, while the price of bitcoin is now trading at $36k. We are currently at a loss of -$2k.
In this diagram, our maximum profit is around $8k instead of $10k.
Would this example be more straightforward if bitcoin's current price is $30k instead of $36k since this requires extra mental maths for you? Yes, but I try to make it realistically and force you to try to calculate with me.
Being "short" while the price goes up
If the price starts to increase, our PNL will start to decrease. However, if we are short-selling, our losses are not limited because we are using borrowed money/leverage.
In theory, the price of an asset may continue to increase, which could lead to an infinite loss for us if we were to “short-sell” the asset.
Therefore, “short-selling” refers to the practice of selling a non-owned asset with the aim of repurchasing it again at a cheaper price in the future. However, you will incur a loss if the asset’s price rises instead, because there is no upper limit on how far the price of an asset may rise, your losses might theoretically be unlimited.
The only thing constraining our losses is the sum we deposited into the account of the exchange we are trading. The amount we deposited is our “margin.”
This simply means that if we deposited $100 into our exchange account, and our margin is 10%, then the most we can lose is $90. If the market moves against us and our account balance falls to $90, then our position will be automatically closed by the exchange to prevent us from losing any more money.
When the price of an asset we are short-selling reaches a certain level, our position gets "liquidated."
A liquidation on a trading platform refers to the platform automatically closing a position to save the trader from losing more money than they deposited.
That is a safety mechanism to prevent traders from declaring bankruptcy and falling into actual debt and going bankrupt.
The level at which our position gets liquidated is called the "margin call level." It is different for every asset and every exchange.
When a position is liquidated, the traders are typically charged a “penalty fee” by the exchange. This fee is designed to cover the exchange’s risk in allowing the investor to trade with leverage. The penalty fee can be as high as 20%.
If you want to trade "spot" or "futures: trading, I highly recommend FTX or Binance.
FTX 10% Fee Discount
My referral link will give you a 10% discount instead of the usual 5% discount from other referral links.
Binance
My referral link will give you a 10% discount instead of the usual 0% discount from other referral links
A quick intro to some of the terminology
What is the meaning of Expiration Date?
An option contract does not trade forever. Option contracts all expire or terminate; there is an expiration date.
Options are dependent on an underlying futures product, and all futures have a settlement date. If the futures contract no longer exists, the option contract on that contract cannot either.
When trading futures options, there are a variety of expiry dates from which to pick. Some of these expiry dates correspond to the expiration of the underlying futures contract. However, other options with shorter durations give more trading strategy flexibility.
Essentially, options with multiple expiration dates provide varying possibilities to benefit from price fluctuations of the underlying asset. Options with shorter maturities are advantageous for traders seeking to benefit from short-term price fluctuations. In comparison, options with longer maturities are more beneficial for those seeking to profit from longer-term Trends.
What is a strike price?
The agreed-upon price, also called the strike price or exercise price, is one of the essential parts of an option contract.
The strike price is the price at which you buy (in the case of a "call option") or sell (in the case of a "put option") the underlying futures contract when the option is "exercised."
The "strike price" is also known as the "exercise price."
The "strike price" is an important part of an options contract because it determines the amount of profit or loss you will realize if the option is "exercised."
If the option is not "exercised," then the "strike price" has no bearing on the profitability of the trade.
The strike price for an options contract can be set at the market price of the underlying contract (i.e., spot or futures contract) when the option is purchased.
However, it is also possible to set the strike price at a specific price, either above or below the current market price.
Call options
A call option gives the buyer the right, but not the obligation, to purchase an asset at a predetermined price (the strike price) at an expiration date in the future.
That means that the buyer of a "call option" contract is not required to purchase the asset at the "strike price." They have the choice to do so but are not required to do so. That's why the payoff is "non-linear."
How the underlying asset’s price moves relative to the “strike price” has an effect on the payoff of an option contract. That’s called “non-linearity.”
The payoff of an option contract is “non-linear” since it is dependent on the price movement of the underlying asset compared to the “strike price.” This implies that modest changes in the price of the underlying asset can have a significant influence on the option’s payoff.
For instance, if the price of the underlying asset is near the “strike price”, a slight change in price may lead to a major change in the option’s payoff.
A call option buyer will profit if the asset price rises above the “strike price.”
A call option buyer will lose his money if the asset price at expiry is below the “strike price.”
A call option buyer will break even if the asset price at expiry is equal to the “strike price.”
We can buy a “call option” on Tesla with a “strike price” of $300
If we buy Tesla shares (not the option contract) at $300, we start to make money if the price goes above $300.
If, however, we buy the stock and the price goes down, then we lose money.
If the stock price is more than $300 at expiration, we would "exercise" our “call option” to buy the shares. We also call this "exercising an option."
We would buy the shares for $300, so we would have earned the same money as if we had bought the stock.
So if the price of Tesla reaches $350, we will "exercise" our right, and the payout for this "call option" would earn us $50 per share.
If, however, the stock ends up below $300, we would not “exercise” our option. We would let it expire, remaining on this horizontal reward line where our loss would not be unlimited.
You get the “Non-linear payoff” when you buy options contracts.
We have to spend initial capital to get a “non-linear” payment, and this initial cost is also known as the “option premium.”
To buy a “call option contract,” we have to spend an initial payment to buy the “call option.” That initial payment cost is known as the “option premium.”
Our maximum loss when buying a “call option” is limited to the “option premium.” The “option premium” price is the maximum amount of money we can lose.
Remember, an option contract provides us with “leverage.” If you’re familiar with futures or margin trading (using borrowed money), you know that your losses can be unlimited until you receive a margin call. Our loss is limited to the “premium” we have paid for the options contract by buying options contracts.
Our loss is limited, but our potential profit is unlimited. When our loss is limited, our profit is unlimited. That’s an example of a “non-linear” payoff.
Let’s assume it costs us $5 to buy a call option.
So when we buy 1 contract of an option, that gives us the right to trade 100 shares. (leverage effect)
So the actual premium we need to pay is $500:
$5 * 100 = $500If we buy 100 Tesla shares at $300 instead of buying call options, we must pay $30k.
In the case of this call option which cost us $5, we already have to spend $500 to buy this. That’s way less capital required than paying $30k for 100 shares.
The appeal of options is the “leverage” they provide. Since 1 option contract controls 100 shares of the underlying asset, buying a call option contract exposes the gains and losses of 100 shares at a fraction of the price of 100 shares.
It means gains amplify when buying options contracts, and losses amplify when selling options contracts.
So for our example, the “call option” contract gives us the right to buy $30k worth of shares, while this “call option” only costs us $500.
If we want to determine the real PNL of this option position, we must reflect the price we paid for the option. For example, if we paid $5 for this option, we must adjust our payoff by the premium amount.
Once we factor in the premium and shift that hockey stick downward, we will lose money if the stock price falls below $300. Below $300, we will lose on the “premium” that we paid. This premium is $5 per share or $500 for 100 shares.
Only if Tesla’s stock price ends up above $300 will we begin to profit on the way up.
Note the adjusted hockey stick that we shifted to the downside due to our pay premium. After that hockey stick (the grey) crosses above the 0-line, we start to earn money on the “call option.”
The point above crossing the 0-line is the “breakeven” point. Only above the breakeven point do we start to generate profits. The breakeven threshold can be calculated by.
Strike price + the premiumIn our situation, the strike price is $300, and the premium is $5. Our breakeven price will amount to $305. If the price is more than $305 at expiry, we will have made a profit on the option buy.
Put options
A put option gives the right, but not the obligation, to sell an asset at a predetermined price (the strike price) at or before the expiration date in the future.
Let’s retake Tesla stocks as our example. We buy a “Put option” with a $300 strike price.
The payoff diagram shows that if we have the right to sell our shares (through a put option), we will start to make money if the stock price falls below the “strike price.” That’s similar to how you would make money if you are “short-selling” with a futures contract.
If the stock price is above $300, you won’t exercise your right to sell your shares. You would rather keep your shares and sell them later at a higher price. So you would stay on the horizontal line at the zero payoff line.
Here again, our maximum loss is limited. The “put option” looks like a “short-position” where we make money on the way down. On the way up, our maximum loss is limited. That non-linearity again, where our loss can’t be infinite.
Since “Put options” make money on the way down, they are often used to “hedge” existing stock or futures positions.
They can be seen as insurance, where you spend the premium as the insurance cost.
If we spent $5 per option, then we can see that the right to sell a 100 shares if we bought 1 “put option” would cost us $500:
$5 * 100 shares = $500 Like before, we need to shift the payoff line down by the premium. You can see that the true PNL is that “shifted” hockey stick that goes down by the premium.
As the stock falls below the strike price, we start to make money. We make back our premium below the breakeven point, which is on the downside this time.
The breakeven point for the “put option” can be calculated with this formula:
strike price - premium = $295
$300 $5 When deciding to buy options, it’s important to factor in at which point your option contract starts to earn money.
The payout for “put options” is a mirrored reflection of the payout for “call options.”
In the Money (ITM), Out of the Money (OTM), & At the Money (ATM) — Moneyness
In our previous examples of Tesla options, we used strike prices equal to the stock price, which was $300. These were “At the money” strikes.
When the strike price is the same or very close to the current price of an asset, we call these options “At the money.”
Both a “call option” and “put option” can be “At the money” at the same time.
Strike prices above the current asset price are “upside strikes.” Strike prices below the current asset price are “downside strikes.”
OTM (Out of the money)
An “Out of the money” Option has a “strike price” that is away from the current market price, such that the option would not be “exercised” if it was expiring today.
If Tesla is trading at $300 and we have a “call option” with a strike price of $350. That “call option” gives the right to buy the stock at $350.
That option is “Out of the money” because we would not “exercise” that right. The strike price is away from the current price of $300.
Let’s take another example. If Tesla shares are trading at $350 but this time own a “put option” with a “strike price” of $300.
We would “exercise” at the expiration date because it’s the right to sell. It’s the right to sell at $300 while Tesla shares trade at $350, which is above the strike price of this “put option.”
So the “Out of the money” option on the downside is the “put option.”
“In the money” (ITM)
if we have a “put option” for Tesla at a strike price of $350, then if the stock price trades below $350, the option is “In the money” because we would “exercise” our right to sell.
Because we are on the diagonal part of the hockey stick payoff, where we would “exercise” our option and sell the Tesla shares at $300
For upside "strike prices":calls options are "Out of the money" options
Put options are "In the money" options
If again, we look at a “call option” with a “strike price” of $300 while Tesla shares are trading at $350. We are “In the money” because the current price of Tesla shares is above the “strike price,” and we would exercise our right to buy the stock.
Options maturity (American & European)
So far, when talking about option expiry or maturity date, we just said that that’s the date in the future when you can “exercise” the option contract.
However, there are two different types of expires. These two other expiries are American and European.
American options
An American expiration option means that you may “exercise” the option at any time between the day you buy the option contract and the date it expires.
Usually, American expiries tend to be single stocks or ETF options. For European-style options, this is a different case.
European options
Europen Options only allow you the “exercise” the option at a specified time on the exact expiration date.
Usually, people don’t “exercise” their American options early, even though they can. They tend to don’t “exercise” their options due to different factors such as dividends and time.
It’s uncommon to “exercise” options early and not economically beneficial. Instead of "exercising" before expiration, you would rather sell your option contract to someone else.
Settlement procedure (Physical — cash settlement)
Another concept about option contracts is the settlement procedure works in the case of American-style options, their settlement physically.
Physical settlement
When we buy a call option, we have the choice to purchase the shares of the. If we buy a put option, we have the choice to sell the shares at the “strike price” and take delivery of the shares you’re buying or deliver the shares to someone else if you’re a seller. In both cases, we can choose to exercise our option before the expiration date.
Usually, people prefer to sell our options before they expire so they don’t have to deal with the hassle of buying or selling the actual shares and let market makers on exchanges deal with it as you might not have the cash in your exchange to buy the shares.
Cash Settlement
Cash settlement is more common for index options like the S&P500 and Nasdaq.
For options that settle in cash, the specific “exchange settlement price” is computed at the precise moment on the expiry date.
All open positions that expire on that date will convert into the appropriate amount of cash, based on whether or not they are “in the money” and have some value. If not, the options will be worthless.
Options trading requires that you understand the settlement. So your option contract is closed out by the exchange you’re trading at, and you have to cash that to replace its value. That’s how a cash settlement works.
Understanding the settlement process is essential to options trading, as it allows you to anticipate the cash and position movements that will occur.
Most traders on Robinhood trade Americans style options with a physical settlement.
The settlement procedure is "cash-settled " for cryptocurrency traders who trade at Deribit, FTX, ByBit, or DeltaExchange.
You’re trading European-style options with a “cash settlement” procedure. The word “exercising” is confusing for you because their derivatives contracts have a “cash settlement” procedure. You don’t have to think or worry about “exercising” an option.
Deribit is the largest cryptocurrency exchange for trading options. Deribit has European-style cash-settled options.
Sign up on Deribit and receive 10% discount on fees for trading futures & options: https://www.deribit.com/reg-572.9826
If you want to trade bitcoin options, your collateral will consist of BTC. Similarly, your Ethereum collateral will be in ETH and Solana.
Due to the need to hedge your risk, it is not the best platform for beginning options trading. Remember trading on Bitmex with Bitcoin collateral.
Options Pricing
Now let’s go over the “underlying price” and “forward price” because they affect the pricing of an option. We need to know the factors that impact the price of an option contract.
The BlackScholes model is a mathematical model used to price options contracts.
We are not going into details about the “BlackScholes model,” but we can at least go over the inputs for the “BlackScholes model.”
The most important inputs into the BlackScholes model are the underlying asset’s price, volatility, time to expiration, dividends, and interest rates. These factors all affect the “premium” of an option contract once you understand that you will be able to construct trades that reflect your view of the market.
Disclaimer: The BlackScholes model assumes that the underlying asset will follow a lognormal distribution. The BlackScholes model doesn’t take into account the possibility of a stock split or a merger. These events can also affect an option’s premium.
The way I can visualize these variables is with this diagram:
Underlying asset’s price (input of the BlackScholes model)
The most important input of the BlackScholes model is the “underlying asset price,” which in many cases is the “spot price.” The underlying asset price is a crucial factor in determining the value of an option.
The “underlying price” refers to the asset price upon which the option contract is based.
The option’s premium is correlated with the underlying asset's price. If the underlying asset price (i.e., spot price) rises, so does the value of “call options” as they get closer to or more likely to become “in the money.”
In contrast, a fall in the “underlying asset price” raises the value of a “put option” contract as they approach or become more likely to become “in the money.”
What is the forward price? (input of the BlackScholes model)
So conceptually, the “forward price” is the “best estimate” of the “theoretical value” of the underlying asset’s price (spot price) when the option contract expires.
If the “underlying asset price” is expected to increase over time, then the “forward price” will be higher than the asset's current price.
If the “underlying asset price” is expected to decrease over time, the “forward price” will be lower than the asset's current price.
The forward price impacts the price of an option contract. If the forward price is higher than the underlying price, then the option contract will be worth more because it gives the holder the right to buy the asset at a lower price.
So, in general, the fair price for a forward contract is
Current cash price + Costs of buying now — Benefits of buying now.If you want more info about the “forward price,” I have a separate blog: https://publish.obsidian.md/rnr/2+forward+pricing/forward+price
Therefore, we multiply the “underlying asset price” by the interest rate, denoted as “R,” until the maturity date and subtract any dividends received on the asset.
The theoretical value of the future price is referred to as “arbitrage-free.” Consider it our starting point for pricing an option contract using the model.
Before determining the option’s value, the Black Scholes model needs an initial point or anchor point. The “forward price provides this information.” It gives a starting point for estimating costs.
The price impact of Interest rates & dividends on the forward price
Dividends are payments that a company makes to its shareholders. If the underlying asset pays dividends, then the holder of a call option contract will receive those dividends.
Interest rates can also affect the price of an option contract. If interest rates are low, then the underlying asset's price will likely increase because people will want to buy it and hold it as an investment. That will increase the value of call option contracts.
If interest rates are high, then the underlying asset price will likely decrease because people will want to sell it and invest their money in something else. That will diminish the value of call option contracts.
While interest rates and dividends are important factors to consider, they have less impact than the underlying asset price or spot price.
The “forward price fluctuates” based on the underlying asset price, and interest rates have a relatively small impact. However, for shorter-term option contracts, the influence of interest rates is more significant. That’s because dividends are less likely to change in the short term, so longer-term option contracts are more sensitive to dividend fluctuations.
Time to maturity (input of the BlackScholes model)
Now we will consider “time to maturity” as a price variable for options.
The time it takes for an option contract to expire affects the price
The “time to maturity” is a key price variable for options contracts. The more time until expiration, the more valuable the contract may be. That’s because there is more time for the market to move and for the option to become more valuable. Thus, time to maturity is a key factor in determining the price of an options contract.
The longer the term of an option contract or the more time to expiration, the more valuable the option contract may be.
For example, if a call option expires in one year, its value will increase if the same option expires in three years. The option has more time to become more valuable and maybe go “in the money” due to the additional time.
Implied volatility (input of BlackScholes model)
In a sense, the implied volatility represents the market participants' expectation or “believe” of the future realized volatility of the underlying contract would be over the contract's life.
Even though we’re calling “implied volatility” an input variable, it’s an output variable.
Option prices that are already determined by the market. Market players observe the option price and use it to determine the “implied volatility.” The implied volatility is subtracted from the option price on the market. To find the fair value of an option contract, we can look at where people buy and sell the option.
The implied volatility is observed in the market, while the market price implies the implied volatility. That allows us to see the market’s blended expectation of future potential movements in the asset.
The contract price is the price at which traders are willing to buy or sell the option. The option contract’s price is determined by the bids and offers of market participants on an exchange. To determine the fair value of an option contract, we examine the prices at which participants are buying and selling the option on the market.
The options market is constantly changing, and option prices reflect this. By analyzing the option price and other factors, we can “imply” the volatility number.
This implied volatility is what we observe in the market and can be used to predict future market movements.
The market prices imply the future potential movements in the asset and options contracts. That allows us to see the market’s blended expectation of future volatility in real-time. These are the main price factors that determine an option contract’s price. (Underlying asset price/spot, time, and volatility).
We must comprehend how changes in these factors will affect the option contract price.
Options Value
Intrinsic value
The intrinsic value of a call option is the difference between the strike price and the current price of the underlying asset, multiplied by the number of shares represented by the option contract if it expires today,
For a “call option” contract, we know that we only have a payoff if the “spot price” is trading above the “strike price.”
The intrinsic value for a “call option” would be:
current price - strike price
However, if the “spot price” minus the “strike price” would be negative because the “spot price” is below the “strike price,” then we know that the option has no payoff. So the intrinsic value is zero.
The intrinsic value can’t be negative. If the underlying asset is trading below the strike price, the intrinsic value is negative, and the option won’t be exercised.
For a “put option,” we need to have the “spot price” below the “strike price” for there to be an intrinsic value. In this case, we would calculate like this:
strike price - spot price If that’s a positive number, that would be the intrinsic value of the “put option.”
The intrinsic value is the minimum value of the option contract.
It’s important to remember the intrinsic value of “At the money” and “Out the money” options contracts are always equal to zero, it can never be negative.
Only “In the money” option contracts have intrinsic value.
The intrinsic value of an option is also known as “moneyness.”
Time value/Theta
An option contract’s time value depends on how much time is left before it expires.
The longer the maturity, the more time value the contract has.
An option derives its value mainly from two sources which are intrinsic value and time value. “Intrinsic value” is simply if the option is “in the money” or not. Time decay is the loss in value of an option contract over time.
If we have a call option with a strike price of $100 while the underlying asset trades at $120
Call optionStrike price: $100
Underlying spot price: $120
Intrinsic value: $120 - $100 = $20This call option is "In the money" (ITM)
Even if an option is currently “out of the money,” it can still become “in the money” as long as there is enough “time” to reach the “strike price” before the expiration date.
Time value refers to the odds that the option contract becomes “in the money” over the lifetime of this option contract.
This time value decays over time, the closer you are to expiry, the more “time value” decays.
So an option contract’s time value is based on how much time is left before it expires. The longer the maturity, the more time value the contract has.
If you’re buying an option contract, the time value (theta) is negative, meaning you’re losing money by holding that option contract because expiry time decreases.
Your option contract will either expire “in the money,” or it expires worthless. The amount of time you have to expire “in the money” is slowly decreasing, and the time decay is becoming larger, eroding your option contract's value.
So as time moves towards expiration, the time value shrinks or “decays.”
Higher implied volatility also means more time value. For instance, if we own a 105% call option, so a 5% “Ouf to the money” call option on a boring stock that moves maybe 1% a day that expires in a week, the probability that this option will be “in the money” is low, so the time value is probably low.
However, if we take that same call option but on a different highly volatile asset like bitcoin, the time value is higher because of the higher “implied volatility.”
But for instance, if the “implied volatility” goes to zero, the time value will automatically go down to zero. Similarly, as implied volatility rises, the time value will increase.
Because by taking “implied volatility” to zero, the asset will not move until the expiry of the option contract.
Therefore, the time value will automatically go down to zero. Similarly, the “time value” will increase as implied volatility rises.
This diagram represents the “intrinsic value” of a call option contract as the hockey stick payoff.
That is the payoff at expiry and is represented on the diagram. The curve above the hockey stick payoff shows the option contract's value today.
However, it must also incorporate the “time value” and the “intrinsic value.” The “time value” of an option contract is the distance or gap between the curve indicating the overall value of the option contract today and the hockey stick representing the option contract expiration.
“Out the money” (OTM) options example
When an options contract is deep “out the money,” there’s no “intrinsic value” as the expiry payoff would be zero.
As we get further “Ouf of the money,” you can see that the curve that includes the “time value” sits closer and closer to the zero line.
The further we get “Out of the money,” the less “time value” there is since the chance of getting “In the money” is so unlikely that the call option contract loses value and barely becomes worth anything
The little amount of “time value,” or lack thereof, is linked to the probability of ever getting in the money.
“In the money” (ITM) options example
This time, the option contract “intrinsic value” is high, as we are sitting above that 45-degree line of the option contract payoff.
Suppose a “call option contract” will expire in one month. Here the option contact’s value will be higher than the “intrinsic value.” That difference is the time value.
As the option contract comes closer to expiration, the time value shrinks or decays. You can see that the entire option contract value will always be greater than the intrinsic value until it expires.
Anyways, note on the diagram below that the curve above it has very little distance above the hockey stick payoff.
The little distance above the hockey stick also suggests a lack of “time value.”
You may question why the option contract has no “time value” while we are “in the money” significantly.
In prior cases, we have shown that time value correlates with the possibility of “making money,” but now we have a lack of time value?
That’s because “time value” is actually about uncertainty. Now that we are so deeply “in the money,” there’s little uncertainty that the option contract will be “exercised.”
That implies that it is nearly certain that when we buy shares at the “strike” (as this is a “call option”) as time moves towards expiration.
If it’s almost 100% likely to happen, then the “option contract” stops acting like an “option contract” and acts as if you had already bought the stock at the “strike price”. Your position will act as if you bought shares as a spot position.
Therefore, the option perfectly follows the 45-degree line, representing a stock position. When a call option is “deep in the money,” it is equivalent to being “long stock.”
There’s no uncertainty about “exercise.”
“At the money” (ATM) example
When the option contract is “At the money” (“spot price” equals the “strike price”)
The graphic depicts the most significant disparity between the “intrinsic value,” which is zero for “at the money” option contracts, and the option contract value is at its widest
So an option contract has the most “time value” when it’s “at the money” that’s because we reach the point of maximum uncertainty of “exercise.” The price may increase or decrease. We just don’t know.
Option contract value as it approaches expiry
The option contract’s value decreases with its expiration date since the “time value” diminishes with time. Regarding the graphic depicting the current option contract value, we can see that as time passes, the curve begins to flatten and approaches the hockey stick payment, which it reaches on the day of expiration.
Suppose a “call option contract” has a one-month expiration date. The option contract's value will exceed its “intrinsic value.” This difference is the “time value.”
As the option contract comes closer to expiration, the time value shrinks or decays. You can see that the entire option contract value will always be greater than the intrinsic value until it expires.
The smooth curve that the option’s value for different “spot prices/”futures prices” has become more distorted as we expire and becomes more like the hockey stick payoff.
Therefore, the real value of an option contract today, some time before expiration, acts like a curve that rests above the option contract’s eventual expiration payoff.
The distance between the “spot price” and “strike price” determines the shape of this curve.
Are we “out the money”
“At the money.”
or “In the money.”
Furthermore, it depends on the passage of time. Is it a beautiful, smooth curve, or is it getting more distorted as the expiry date nears?
You become a more “skilled” options trader if you understand how the premium of an option contract behaves in space and time.
You will be able to develop positions with enhanced risk profiles and capitalize on possibilities for options trading.
Options chain
In this section, we will examine an “options chain” and how to analyze the various trading “strike prices.” You may witness the influence of pricing and available expiry dates on the market. Read strike prices from an options chain (Deribit example)
So here’s the “options chain” for bitcoin. The maturity date we selected is June 24 (2022). Quarterly options. First, let’s begin with Deribit exchange since they are the largest exchange for trading bitcoin options.
Sign up on Deribit and receive 10% discount on fees for trading futures & options: https://www.deribit.com/reg-572.9826
The current “spot price” for bitcoin is around $29880
This table displays how the option contracts are structured.
On the left are “call options,” and On the right are “put options.”
The strike price is the center bar labeled “strike.” Both the bid and ask prices for options show.
We can see both the bid and ask prices for options. The graphic on the left side of the “options chain” depicts the bid and ask prices for “call options.”
The bid-ask prices are shown on the right side of the “options chain” in the illustration below.
As mentioned before about “implied volatility,” there’s also on both sides a bid and ask offers for “implied volatility” (IV)
For the $30k “At the money” options, the “call options” have an implied volatility of 76.3%.
The “put options” also give us 76.3%
As previously stated, “implied volatility” is the model's output obtained from the option contract prices.
Let’s check the options chain for the S&P500 (spot price trading at $415)
https://www.barchart.com/stocks/quotes/$SPX/options
The model, the internal model of this trading platform, computes the center of the bid-ask spread and “spits out” or “returns” 31.92% or an average of 31.1% as “implied volatility.”
For the put options on the S&P500
It has an “implied volatility” of 31.95% or an average “implied volatility” of 31.1%. Therefore the “call” and “put” of the same strike are almost identical.
Same “strike” option contracts with the same expiration date will have the same “implied volatility.”
After examining “At the money” options, let’s examine “Out of the money” option contracts. We must look at higher “strike prices” for “call options” that are “out of the money” since such options are “out of the money.
The more we scroll down, the higher “strike prices” we see—the screenshot's “strike prices” range from $31k to $70k.
As we go through higher “strike prices,” the prices for those “call options” are dropping. The cost to buy these options is getting cheaper. The prices are getting lower and lower.
The further options are “out of the money,” the closer their costs approach zero, as “time value” and the likelihood of being “in the money” decrease.
In the same scenario for “put options” contracts, the lower “strike prices,” the lower the cost/premium of these options.
The more “out of money” we go on the “options chain,” the premium of the options contracts goes down, as we would expect.
So if we look at the corresponding “call option” that has the same “strike price,” the only difference between the “call” and the “put” is that one of them got “intrinsic value.”
One is deeply “in the money,” while the other is “out of the money.”
However, the $570 “time value” of this “put option” is also the “time value” of this “in-the-money” call.
You can see that the price of the “In the money” call option is just the “intrinsic value” of the “in the money” call option, which would be the difference between the spot price ($30023) minus the strike price (2500)
30023 − 25000 = 5023And then we add the price of the “put option,” and that’s what roughly the cost of the call option will be
5023 + 1264.90 = 6287.9
As you can see, the price of the “call option” with a “strike price” of 2500 is ~$6293
We can see a slight difference, and that difference is due to the “forward” and the fact that we are pricing options of the “forward,” which might be slightly less or more due to the interest rate (rho). For stocks, It can be due to dividends and factors like that.
However, I am trying to explain that these “deep in the money” call option contracts contain a lot of “intrinsic value” and are thus quite valuable. In addition, they received a small amount of “time value” due to their distance from “at the money” strikes, but a substantial amount of premium.
You can also see columns for “Delta,” which is a topic for part 2 of a new article.
Disclaimer: Use limit orders when trading options. Don’t use market orders! The spread can be wide and unfair. Check the implied volatility too before making irrational decisions
How to read expirations on the option chain (ByBit example)
This section will examine the various expiry dates and maturities. Since the ByBit exchange has introduced options trading, we will review their options and options chain.
You can see this short-dated “at the money” calls are around $1500
Now, if we check the option contracts with longer expiry, let’s select the July options and see the price/premium for an “at the money” call option contract with that same “strike price.”
The price has gone from $1500 to $4120 for that same “strike price,” but two months later.
You can see that the longer maturity by around two months makes the premium of that same “strike price” option much higher.
Why? Because there’s more “time value.”
As the maturity is further in the future, the value of the options goes up because they have more “time value.”
Should I trade on ByBit?
There is an opportunity, yes. If you are now trading futures on ByBit or planning to, you will also be able to trade options.
Options trading on ByBit is much easier than on Deribit. That would be simpler for beginners.
Why you may wonder? When trading on Deribit, the collateral is held in BTC, but on ByBit it is held in USDC.
Typically, when new traders join Deribit, they forget that their collateral is in BTC, resulting in incorrect hedges and computations.
As some of you may recall, trading on Bitmex with 1x leverage is equivalent to 2x leverage since your collateral exposes you to 1x leverage already.
Liquidity still has to improve but that will happen in the future.
ByBit Options (Discount on fees and $100 deposit bonus): https://www.bybit.com/register?affiliate_id=6776&group_id=1653&group_type=1
Trading platform: Delta exchange
Another new exchange called “Delta exchange” has options trading for multiple altcoins. You could use these options to hedge your portfolio for altcoins. Here we can see the options chain for Avax.
The fact that your collateral will be stablecoins rather than BTC or ETH is an additional incentive to favor Delta Exchange over Deribit, in addition to the availability of altcoin trading choices.
If you are new to options trading, I would recommend Delta Exchange and ByBit over Deribit. After learning how to hedge your collateral on Deribit, you can use Deribit.
If you’re seeking to signup and want a 10% discount
You can use my referral link
Trading platform HXRO (Gamified option trading)
Another exchange called “HXRO” gives a bit of feeling like trading on Robinhood, which might be helpful for beginners to get a feel or introduction to options trading.
I’m not here to make judgments about putting “options trading” at people’s fingertips in a “fun,” and gamified format with practically no other market maker than “Alameda Research” (The guys behind FTX exchange) is a good thing.
You can try it out yourself. You choose a prediction for a price if it will hit yes or no, and request a quote.
You can’t place limit orders, and it’s most likely Alameda Research giving you a quote after you request it.
They give you a quote. The market makers (Alameda Research) most likely charge you a higher unfair premium. They will take your trade agast them and hedge it out somewhere else. Most won't notice since it’s a fun gamified way aimed at retail traders, most won’t see.
The probability seems somewhat equal to Deribit, which shows a similar delta for that same strike which is 0.3
(Sometimes, I use the “delta” in a practical sense to estimate the likelihood of an option expiring “in the money.”)
The probability estimations seem at least fair. You could try it out if you're a beginner and gamble with $10–$100, but I don’t recommend it if you're a serious trader.
Suppose you want to try it out to get a feeling for a start and do some practice in a “fun” gamified way. Well, I’m not here to make judgments. I started playing with HXRO 2 years ago to test out and play.
Since I give HXRO exposure, I might as well just put my referral link in
I promise they don’t sponsor me or ask me to write this.
HXRO, if you guys are reading this, for the right price you can call me ;)
DeFi
These DeFi protocols also use options like this protocol built on Solana.
Stay away from trading options contracts on these DeFi protocols. They falsely advertise themselves and appear like it’s “free money” and “risk-free.”
Also, the market makers for these options are most likely hedge funds like 3AC, who will happily give you a terrible price and hedge that away on an actual options exchange like Deribit.
Use an actual exchange to trade options contracts and receive better prices. These DeFi option protocols are predatory, and I won’t recommend using them. It comes close to robbing people with its false advertisements.
Sign-up for an actual exchange. I know KYC might be a pain, but it’s worth it.
Final words, announcements, and more
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As I’ve mentioned before
You have learned in school, on television, or YouTube how to visualize atoms, protons, neutrons, electrons, etc.
This model is entirely inaccurate, yet we use it because it helps us visualize the specifics of these abstract subjects.
Consider everything in this article to be an oversimplification to assist you with more advanced reading about options trading
This article was part 1 of my article series about options contract trading.
I will publish as a part 2, and I will cover “option Greeks.” What they are and how to use them when evaluating option trades.
So you will understand what I mean with
The tail that wags the dog
If you scroll down the article, you can see a “Todo” list for parts 2, 3, and 4 of the following articles about options trading.
More medium articles?
If you are looking for more medium articles like this written by me, you can find them here.
Twitter: https://twitter.com/RNR_0
If you liked this article, you will probably also love this article about FTX MOVE contracts.
Scroll down from what you can expect from the following articles about options contract trading
Part 2, 3, and 4 of the options trading article (coming sooner or later)
A useful tool for trading options: https://tools.deribit.com/options-discovery?index=BTC
A lot of this stolen (I mean adapted) from
books:
Reddit: https://www.reddit.com/r/wallstreetbets/comments/k2a2j8/options_explained_a_quick_beginners_guide/
And some other posts I can’t remember
Next article for part 2
Options greeks
