Despite ongoing vaccination efforts and pandemic aid, the world’s economy looks remarkably different than it did over a year ago. The new financial landscape and continued uncertainty have accelerated the shift away from traditional financial institutions.
As the economy attempts to roar into high gear from a standing start, the world of cryptocurrency has taken to the main stage. It has cemented itself as a recognized asset class by major asset managers, investment banks and hedge funds. As the speed of mainstream adoption continues to take the financial world by storm, it is also paving the way for investors to explore a new frontier — crypto options.
What are options?
Options are financial contracts that allow investors to buy or sell the underlying asset, at a set price, at a future date. This allows investors to take directional bets on the price movement of an asset. Investors that expect the asset to appreciate in value can purchase call options from which they will profit if the market price of the asset exceeds the strike price. Contrarily, if they believe the asset will depreciate in value, they can purchase put options, which will bring in profit when the market price of the asset falls below the strike price.
When these conditions are met, investors can choose to exercise their option, requiring the issuer to buy or sell the underlying asset from or to the investor at the strike price. Or, they can simply trade their options to others to realize a profit.
Truth about options
There are several features inherent to options that make them more palatable to investors, especially in a volatile market. With options, investors are able to gain exposure to larger positions at a fraction of the cost. For example, consider buying 100 shares of a stock at $50. In order to be in this position, an investor would need to have $5,000 in capital. With options, however, the cost can be significantly reduced. The same investor can gain the same exposure to a stock or cryptocurrency by buying an option for a fraction of the cost, say with a $150 premium.
Options are a powerful tool in empowering investors to capitalize on the volatility of the markets and enable investors to participate in the markets while freeing up capital, allowing them to diversify their strategy and take on a larger number of positions.
Options also allow investors to gain exposure to the market volatility. Since the price of an option is directly correlated to the market volatility, options tend to get more expensive in a volatile market. Thus, an investor holding a long position in an options contract stands to gain from the market volatility too.
The biggest use case for options, however, is their usage as risk management products. Investors can buy put options (or bet against the market) in order to hedge their portfolio when they are uncertain about market upside. This is like buying insurance on your portfolio in order to protect it from market volatility or down-
Institutional frenzy for options and crypto
As institutional interest continues to grow for the cryptocurrency markets, so has institutional appetite for crypto options. Strategic investors have found refuge in the idea that options allow them to capitalize on the volatility of crypto markets to capture high profits while at the same time keeping them away from higher-risk investments. The volatile nature of crypto markets creates an urgent need for investors to be able to diversify their strategies and hedge their positions while still getting exposure to the upside.
Options markets have given investors a chance to play the field, invest strategically and study the market. Even during what some are calling a bear market, this has kept activity.
The buck doesn’t stop at institutions
The power that options offer for individuals is being realized by an increasing number of retail investors too, even in the midst of global economic uncertainty. According to Trade Alert, 2020 was a record year for the options market in terms of volume traded, with 7.47 billion contracts traded. This trend continued with conviction into early 2021.
Surprisingly, most of the increase in volume was contributed by retail investors. An article by Barron’s highlighted that options brokers such as Schwab have seen a 116% increase in options being traded. It is estimated that 60% of all options being traded are from retail investors, evidenced by the position size being less than 10 contracts. In fact, the number of single contract trades has doubled in the same time period.
As we progress through 2021, major names such as Goldman Sachs have also announced expanding their crypto presence by offering options trading in Ether (ETH) after seeing huge institutional demand. These products will also apply to their retail customers and are sure to reduce some of the leverage in the system, creating an easy onramp for investors.
Today, centralized exchanges are better equipped to handle retail demand for options. They don’t suffer from network congestion experienced on Ethereum, leading to instant execution of trades with lower fees.
That doesn’t rule out the innovations that come with the accelerated rate of decentralized finance. DeFi has disrupted many traditional financial industries, and it is looking to make options more readily available. Decentralized exchanges will play a key role, in the future, in connecting retail investors to options as its ecosystem continues to evolve.
With the economic impact of the global pandemic expected to last until 2025, cryptocurrency markets will, without a doubt, remain volatile. DeFi applications and centralized exchanges are diligently working towards bringing more and more cryptocurrencies to the options market and evolving to simplify complicated trading strategies for investors.