Options contracts have emerged as a vital tool for investors in the crypto space, offering unique opportunities to hedge risks and safeguard portfolios in an ever-changing market. Understanding the fundamentals of options and their application is crucial for navigating the dynamic world of cryptocurrency trading. This article explores the advantages of options trading and how they can safeguard portfolios while maximizing potential returns.
Basically, what is an options contract?
Options contracts belong to a group of four prominent financial derivatives instruments, which also include futures contracts, swaps contracts, and forward contracts. With options, individuals can engage in contractual arrangements to buy or sell assets at predetermined prices and specified future dates. The two primary types of options are call options and put options, offering participants the flexibility to take either long or short positions.
An options contract is a contractual arrangement that grants participants the right, but not the obligation, to buy or sell assets at a predetermined price and time in the future. There are two primary types of options: call options and put options.
Buyers of options contracts, known as holders, have the opportunity to go long by paying an option fee or premium to the seller. This fee provides them with the right to buy (in the case of call options) or sell (in the case of put options) the underlying asset at a later date.
Sellers of options contracts, also called writers, assume the obligation to fulfil the terms of the contract if exercised by the buyer. Once established, options contracts cannot be cancelled, and the underlying asset must remain encumbered until the contract reaches maturity.
One of the most common and effective uses of options contracts is hedging risks and protecting investment portfolios against significant fluctuations. By strategically employing options, investors can minimise potential losses caused by adverse market movements. This risk management tool enables individuals to navigate market uncertainties while optimising their investment positions.
Not only that, options offer investors the unique advantage of multiplying their initial investments by several times. With the potential for significant gains ranging from 5 to 20 times or more, investors can capitalise on market opportunities while acknowledging the associated risks. Options provide a balanced approach to earning substantial profits while managing the potential downside.
Let's consider the case of Mr. Smith using options to protect his investment portfolio:
Assuming the current spot price of ETH is $1000, Mr. Smith anticipates a fluctuation of +-20% over the next week.
Instead of investing $1000 to buy one ETH outright, Mr. Smith decides to purchase an ETH call options contract on Friday, which requires a smaller investment known as the options premium (typically 5% of the total value, in this case, $50).
On the expiration date:
If the price of ETH increases to $1200, Mr. Smith will profit $200 – $50 = $150, representing a 300% return on his initial investment. This is a significant gain compared to a direct investment of $1000, which would only yield a 20% profit.
If the price of ETH falls to $800, Mr. Smith’s loss is limited to the options premium of $50, instead of the full $200 if he hadn’t purchased options. This loss represents only 5% of his initial capital invested in ETH.
By using options contracts, investors like Mr. Smith can mitigate risk and seize opportunities. Options offer a smaller investment with the potential for substantial returns, providing more opportunities and time to generate significant rewards.
Whether investing in equities or cryptocurrencies, options contracts serve as a risk reduction strategy. In the event of a stock or cryptocurrency price falling below expectations, investors can utilise put options to compensate for the loss. Understanding options is essential for both short-term and long-term outcomes, allowing investors to navigate the financial markets more effectively.
In contrast to futures contracts that derive value from asset differentials, options contracts derive their value from market volatility. This characteristic makes options a valuable tool for managing risk and mitigating potential losses when investing in underlying assets. Specifically, investors can utilize put options to minimise losses in the face of adverse price movements, effectively safeguarding their holdings against declining stock prices.
The utilisation of flexible options has proven effective in protecting assets against market fluctuations. By relying on future price expectations, options contribute to a more stable trading environment, thereby limiting the potential for abrupt market volatility. This stability is a crucial factor for sustainable and steady market development.
In light of these benefits, it becomes essential for individuals to equip themselves with knowledge of options in order to become proficient financial investors. This is especially true in the present-day context of the cryptocurrency market, which is characterised by significant fluctuations. The allure of this market presents an opportunity for the development of financial instruments, and understanding options becomes paramount for investors looking to capitalise on this potential.
