Big day for Bitcoin - How will the options contracts work?

Today is a massive day for the worlds global digital currency!

Much of the digital community wonder what it takes for Bitcoin to go mainstream, Options contracts are a big part of that. Financial institutions are all worried about investing in Bitcoin because of its volatile nature. Options solve this problem as they can act as a hedging tool to reduce said exposure to the extreme price swings. 

How do options work?

Options contracts are a contract to insure that a particular price will be paid for an asset in the future. The buyer of an option can either make sure they pay a certain price for the Bitcoin in the future or let the contract run to expiry and pay the premium. Let's examine this further. 

You buy a call if you think the price will rise. You buy a put if you think the price will fall.

The strike price is where you think the price of your option could surpass once the contract has expired

Example:

Let's say you pay $100 for a 1-month call contract with a strike price of $8K for 1 Bitcoin. 

In 1 months time if the price of Bitcoin goes higher than 8K the buyer of the call makes money as they have the option to buy at 8K. 

As they paid $100 for that option if the price doesn't get near 8K that is all they are liable for this is the premium.

Now there is an interesting point about option contracts and that is called volatility. If on the day you buy a options contract the price starts to get very volatile in your direction. The price of the contract will start to rise. So then you can sell it for a profit, even if it does not reach 8K. So this means even 1 or 2 weeks into the contract if the price goes mad, you could make money even if it does not reach your strike price target. 

This works the same with put options. This is when you buy an options contract hoping that the price falls. For example, if you by a 3 month put with a 6K strike price for $300 you want the price of Bitcoin to fall. Now let's say a week after you buy the put contract the price falls rapidly toward your target but doesn't reach it your contract will be worth more because the chance your strike price is about to get hit becomes higher. 

Time plays a massive role in options contracts as the further into the contract you go the less likely your target may be hit. This needs to be put into context. So if you buy a 1-month put or call and the price doesn't move much in the first 3 weeks it will be less likely to hit your strike price than if the price went crazy (volatile in your direction) in the first week. I liken this to a bet in a football game. If you bet on England to beat Scotland and they score an early goal you get to cash out for more. But the longer the game goes and nobody scores the less your cash out is. Options contracts are exactly the same. 

The time horizion of the puts and calls is dependant on what is on offer from the broker or exchange. There usually are 1,3 and12 month time horizons.

How to use them with spot

So traders use options with the spot price to hedge their positions. So if you are a "holdler" at 7K to protect your position you may buy a put contract with a 3-6 month expiry under 6775. So if the price moves far under the 7K level you can take a profit on the put option contract while you lose money in spot.

This is the key to trading spot vs options. Options are used by financial institutions to hedge. So you may think Bitcoin will reach 20K again once again but in the meantime, you can profit the further the price moves away from where you bought. 

This is the most common way options contracts are traded in the financial markets. As traders may hold long term positions and trade around them with options contracts.

Premiums

The price of options is governed by the amount of volatility. So if there is a period of very low volatility price will be cheaper and if the price is swing around then the prices of the options contracts will move higher. 

This is simply because the people selling (market makers) the options contracts cant keep the price the same if it becomes more likely the strike price will be hit. They need to make money from premiums too. 

If options prices become higher it is because your strike price is more likely to be hit. This is calculated by a mathmatical model called Black and Scholes.