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Options trading may appear intimidating initially, but learning its basic concept will simplify the matter. Unlike crypto futures or perpetual swaps, buying crypto options may provide investors with a low-cost and low-risk strategy.
An “option” gives the buyer the right to buy or sell an underlying asset at a specific price. After understanding the general rules that govern this financial niche, we will look into its crypto applications.
Understanding Financial Options
Options are a kind of derivatives, a large category of securities. The price of a derivative follows the quote of another underlying asset.
From a practical point of view, many brokers allow buying and selling financial options on the market. Options are contracts that provide the bearer the right, but not the duty, to purchase or sell the underlying asset. Different options set different predetermined prices and maturity dates.
Why do people buy options? In short, these contracts can help to diversify a person’s portfolio. They do so by increasing their revenue, providing protection, and even leveraging their position.
If you are looking for an example, think of the stock market. A famous example is using options to hedge against a falling stock price to prevent downside losses.
A professional trader can obtain a good income from options trading. Hedge funds frequently use options for speculative objectives, such as betting on a stock’s future direction.
It is worth mentioning that options trading is a complex strategy. Traders dealing with the derivatives market should be very cautious. It is not by chance that most brokers have risk disclaimers when they allow operations on options.
Let us divide the options market into two categories:
- Put: an option giving the right to sell the underlying asset.
- Call: conversely, a call is an option allowing traders to buy the underlying asset.
Each contract contains at least two pieces of information:
- Strike price: the price at which the contract buyer has the right to purchase or sell the underlying asset.
- Maturity date: the deadline by which traders must choose to use the option right or sell it.
Now that we have clarified the general notions let’s understand how traders use options to earn money.
When Do Options Traders Earn Money?
The financial industry has its way of pricing the cost (or “premium”) of an option. Several mathematical models exist to do so, but we will avoid being excessively technical in this quick guide.
The readers need to know that the price of an option follows the variations of several variables. Among these, we have the price of the underlying asset, its implied volatility, and maturity date.
The general concept is that a trader buying a put does so as downside protection. The opposite is true for call buyers, as one may guess.
The market can find itself in three cases:
- In the money (ITM): For a call, this means the strike price is lower than the underlying asset’s current price.
- At the money (ATM): When the strike price of a call or a put is equal to the current price.
- Out of the money (OTM): When the strike price of a call is greater than the current price of the underlying asset.
Traders may buy a call option with a lower strike price than the underlying asset’s current quote. Intuitively, the cost of this option will be higher compared to those having a greater strike price.
This efficient pricing system excludes the case of “free lunch” in the options market. Options traders tend to anticipate future movements in the underlying market. Consequently, many analysts look at these instruments to obtain information on the market sentiment.
A Crypto Example
We believe it is fundamental to see all the theoretical concepts we have just introduced in a real-life case.
Suppose that a group of traders observed the current BTC price ($44,000) and expected it to increase. Investors may buy 100 call options with a strike price of $46,000 and a 0.002 BTC premium. The maturity of this contract would be March 31st.
At this point, we just need to follow the math. A 0.002 BTC premium at $44,000 implies a value equal to $88. Considering that the group bought 100 call contracts, we obtain $8,800.
Each of these contracts will let traders buy 0.01 (i.e., 1 divided by 100) BTC at $46,000 per token. In other words, investors can purchase 1 BTC at $46,000 by the end of March.
Now, suppose the BTC price hits $55,000 before March 31st. The group of traders can exercise the call option and earn a profit.
How much would they earn? Once again, the math is pretty simple. The difference between the market quote and the strike price is $9,000. If we take away the cost of the option ($8,800), the traders will earn $200.
Let us imagine, however, a catastrophic scenario. What if the BTC price moved to $20,000 by the end of March? In this case, traders would not exercise the option, and they’d lose the premium of $8,800.
This position is safer than that of somebody investing on the spot market. Anyone buying 1 Bitcoin at $44,000 and selling it at $20,000 would end up losing $24,000.
The Risk of Crypto Naked Option Trading
There are many different strategies in the options market. One of the most popular is the so-called “naked” approach. Simply put, it means taking an options position in the underlying asset without opening its opposite one.
Traders who sell a call, for example, are basically shorting the underlying asset unless they also buy it. Selling naked calls (to purchase) and puts (to sell) is a riskier position that can result in significant losses.
Ideally, inexperienced traders should not make use of this strategy. Generally, a better idea is to use options to cover an existing investment.
When you know the fundamental ideas of options, they don’t appear difficult to understand. When utilized effectively, options can give good opportunities on the market. However, the wrong usage of options can have dramatic effects.
A robust research phase can help us understand how the market will likely move in the future. However, exact predictions do not exist. This is why options are popular instruments among traders who want to minimize losses.