What is an option?

Options contracts are derivatives of underlying assets. They enable buyers and sellers of contracts to amplify returns, manage risk, and generate income. For this reason, they are rightfully revered as the most dynamic of all financial instruments. Buyers of options contracts (calls or puts) have the right, but not the obligation, to buy (in the case of calls) or sell (in the case of puts) the underlying asset at a predetermined price (i.e., strike price) on or before a predetermined date (i.e., expiry). This process is referred to as exercising an option. Using options, investors can increase their potential returns if underlying assets move in a favourable direction or hedge against potential losses that would result from underlying assets moving in an unfavourable direction.

If you expect the price of a particular asset to appreciate, you could amplify your exposure to the potential appreciation by purchasing a call option. Conversely, if you expect that a particular asset will depreciate, you could amplify your exposure to the potential depreciation by buying a put option. Options strategies can also be configured to profit from volatility or a lack of volatility; this characteristic is essential for directionally ambivalent traders.

Options offer portfolio enhancement utility in any market regime, ranging from upswings to downturns, to sideways drifting markets. Advanced options strategies, such as trading spreads, enable investors to trade off potential upside in return for a greater probability of profit and the ability to precisely define the max loss of their positions. Like with any sharp tool, the efficacy of an options strategy will be determined by how it is deployed.

Options Premium

The fee paid upfront to purchase an option is known as the premium. The value of an options contract fluctuates throughout its lifespan in response to the price performance of the underlying asset, distance to strike price, volatility, time decay, and interest rates. Options contracts can be sold before expiration, in which case PnL (Profit and Loss) is dictated by the difference between the premium paid upfront and the premium collected from selling-to-close the contracts.

The break-even point for an options contract refers to the point at which the exercising of an option would result in zero net gain or loss. It is equal to the difference between the strike price and the price of the underlying asset at the point of expiry (i.e., exercise price), minus the premium paid upfront for the option (i.e., the initial debit).

Bid-Price vs. Ask-Price

Buyers in the market are willing to pay a certain amount for an options contract. This is referred to as the bid-price. Sellers in the market are willing to collect a certain amount for the sale of their options contracts. This is referred to as the ask-price. Logically, the ask-price will always be greater than the bid-price. The difference between the bid-price and the ask-price is known as the bid-ask spread. This is simply the difference between what the highest bidder is willing to pay and the lowest price at which a seller is willing to accept.

The bid-ask spread is a measure of the supply and demand in options markets. The liquidity of markets can be gauged in part by the bid-ask spread. Depth is another important aspect of the bid-ask spread. The more orders there are on both sides of the market, the tighter the bid-ask spread will be.

Market makers supply liquidity by placing offers to sell at a certain price and buy at a certain (lower) price. In return for this liquidity provision, market makers collect the difference between their bid and ask offers (i.e., the bid-ask spread). Generally, tight bid-ask spreads are indicative of liquid markets, whereas wider ones are indicative of illiquidity. Naturally, the popularity of an asset is a key determinant of its liquidity.

Asymmetric Risk-Reward Profile

The bearer of an options contract gains capital-efficient exposure to the performance of the asset underlying the contract. The multiplier on Zeta Markets is 1 (i.e., there is no multiplier). That is, the number of tokens underlying each contract is one. Stock options — traded on NASDAQ — for example, represent exposure to 100 shares of the underlying stock. In the case of crypto options, leverage is implicit. A buyer may purchase a contract for a mere fraction of what buying a token outright would cost.

When buying options (calls and puts), max loss is strictly defined by the premium paid for the contract. Max profit for calls is unlimited. For puts, max profit is limited only by the distance between the contract’s strike price and zero, minus the premium paid. Selling options comes with more risk, but the associated risk can be controlled by purchasing countervailing options.

The asymmetry between max loss and max profit is responsible for the attractive risk-reward profile for which options are known. This property is the crux of a phenomenon known as convexity, which will be discussed near the end of this primer. Properly implemented options strategies allow investors to pursue their investment objectives with minimal capital outlay.

Option Styles

American

Contracts may be exercised at any time, including on the day of expiry.

European 

Contracts may only be exercised on the day of expiry. 

Bermudan

Contracts may be exercised on a fixed set of dates.

The key distinction between different styles of options is how they can be exercised. American and European style options are the two most widely seen types of contracts. Bermudan options are a less frequently seen exotic variation. The phraseology is not related to the region in which the options are traded, though pilots often assume otherwise, and avoid trading Bermudan options.

American-style options give contract holders the ability to exercise an option at any point from purchase until expiry. European options, in contrast, can only be exercised on the date the contract expires (i.e., expiration day). Bermudan options are a hybrid of American and European style options; they may be exercised before expiry, but only on a limited number of specified dates; often on one day each month.

The vast majority of crypto options are European-style. European options offer investors more certainty than American or Bermudan options, as their execution is limited to the day of expiry. As a result, sellers of European options are exposed to less risk and European options trade at lower premiums relative to American options. A key advantage of European options is their utility in systematising hedging strategies. Since both parties (buyers and sellers) are aware of the exercise date before entering the contract, the risk of contracts being unexpectedly exercised is removed from the equation.

Investors selling American options contracts face the risk of contracts being exercised at the will of their holders. This could be at any point in advance of expiry, perhaps upon a sudden and temporary gap up in the price of the underlying asset. In the case a buyer holds an American option until its expiry, they would have fared better had they purchased a European option, as a lower premium would have been paid upfront.

Cash-Settlement vs. Physical-Settlement

Options contracts are settled via cash or physical delivery of the underlying asset. Settlement occurs when an option expires. Cash-settlement entails making a cash payment in lieu of physically delivering the underlying (i.e., the result of the trade is simply reflected in an investor’s PnL). Cash-settled options are usually European-style and offer a smoother experience to all parties involved in the trade by simplifying the process.

Physically settled options contracts are not resolved until the seller transfers the underlying asset to the buyer. Cash-settled options are settled by the payment of the difference between the exercise value of an option and its strike price on its expiration day. Cash-settled options provide buyers and sellers with the ability to dynamically express their market views without hassling with delivery or reception of the underlying asset.

This comes with the benefit of default protection and implicit time savings. Cash-settled European options on Zeta are programmatically executed on expiration day. Contract holders do not need to take any action to facilitate the exercising of contracts. That means your contracts will be settled for you, even if you are in the deepest stage of your sleep cycle, dreaming about a euphoric bull market.

Implied Volatility (IV) vs. Realised Volatility (RV)

Implied volatility (IV) is a metric that aims to forecast the expected price performance of an asset. IV is integral to options markets and is a key determinant of options pricing. High IV increases the extrinsic (expectation) value of an options contract, and thus its premium. Accordingly, options sellers collect higher premiums when selling options contracts with high IVs.

Excluding IV, all other options pricing inputs are known, which is why trading volatility is so popular. Market participants can take advantage of changes in IV pricing and craft their options strategies in accordance with their market sentiment. Realised volatility (RV), also known as historical volatility, indicates how the price of the underlying asset has moved over time. This is opposed to IV, which is the market’s best estimate of what volatility will be realised in the future.

Options traders can use RV to contextualise the IV being quoted by the market. Markets tend to overestimate IV, which provides an opportunity for savvy traders who strive to capitalise on perceived mispricings of IV. Historically, IV tends to revert to the mean, which makes contrasting it to RV quite useful.

Intrinsic Value vs. Extrinsic Value 

In the context of options trading, intrinsic value is the difference between the price of the underlying asset and the strike price of an options contract. For example, if a SOL put option with a $42 strike is purchased and SOL falls to $36, then the contract’s intrinsic value would be $6 ($42 - $36 = $6). Extrinsic value refers to the time or expectation value component of an option’s premium. If the aforementioned contract had a $9 premium, $3 of that premium would be extrinsic value ($9 - $6 = $3).

The premium of an option consists of intrinsic and extrinsic value. The extrinsic value of an option can be inferred by subtracting intrinsic value from the total premium (premium - intrinsic value = extrinsic value). On Zeta Markets, options pricing is calculated using a derivative of the Black-Scholes Model (BSM), called Black-76, which takes into account the following parameters:

• Future Price, S

  • The model assumes future price to be a fixed, positive value, arrived upon using three inputs; oracle-derived underlying price, risk-free rate, and time until expiry. 

• Volatility, σ

  • The degree to which the price of the underlying asset is expected to fluctuate before the options contract expires. It is calculated using the volatility surface that Zeta maintains.

• Strike Price, K

  • The predetermined price at which an option can be exercised (on expiration day).

• Expiry Time, T

  • The amount of time remaining before an option expires. 

• Risk-Free Rate, r

  • Zeta stores a risk-free rate curve that renders an interest rate, representing the theoretical rate of return on an investment that carries zero risk.

The Black-76 model is colloquially referred to as Chad-76, probably, though there is minimal, if any, written account of this terminology being used. It appears to be an underground term of sorts — used by only the most refined options traders on the planet. Near-dated options contracts have less extrinsic value than far-dated ones, as there is less time for the price of the underlying asset to fluctuate.

As an options contract approaches expiry, its extrinsic value gradually erodes until, ultimately, only its intrinsic value remains at the point of expiry. The premium of an options contract is the sum of its intrinsic and extrinsic value. Extrinsic value is significantly influenced by IV, considering IV is effectively a distillation of market sentiment, derived from a set of predictive inputs.

Options Greeks

Options “Greeks” are a set of risk parameters used by options traders to inform their position entry, exit, and management. There are five primary Greeks used by options traders:

• Delta

  • The sensitivity of an option's theoretical value to a change in the price of the underlying asset. 

• Gamma

  • A measure of the responsivity of delta to price changes in the underlying asset.

• Theta 

  • Quantification of the rate at which an option loses its value over time. 

• Vega

  • A measure of an option’s sensitivity to the volatility of the underlying asset. 

• Rho

  • A metric describing relative price changes between options and risk-free rates.

Delta is typically represented as a number between one and minus one. It signals how much the value of an option should change when the price of the underlying stock rises by one dollar. Bullish strategies have a positive delta while bearish strategies have a negative delta. Investors use delta to better understand their directional exposure in the market. If a call option has a 0.35 delta and the underlying asset increases by $1, the owner of the option would expect the option’s price to increase by $0.35.

Gamma refers to the rate of change of an option’s delta in response to a one-point move in the price of the underlying asset. Gamma informs how an option’s delta will fluctuate, making it a particularly useful metric for traders interested in gauging the acceleration characteristics of an option’s price. The sensitivity of gamma is greater for options nearing expiry.

Vega measures the reactivity of an option’s price to changes in the IV of the underlying asset — it is expressed as a decimal value that describes the change in price an option contract will incur upon a one percent change in the IV of the underlying asset. Vega will be higher when an option is at-the-money (ATM) or still has significant time value remaining. Time and volatility are both positively correlated with the likelihood of an option’s price fluctuating.

Theta is a measure of how much extrinsic value an option will lose every day up until it expires. Theta decay describes how an option’s premium erodes with the passing of time. An option seller is harvesting theta decay, whereas a buyer is exposed to its predations. Naturally, as options approach expiry, the rate of theta decay increases.

There are also minor options Greeks, such as rho. These minor Greeks are less frequently referenced and utilised, though they certainly do have practical applications. They will be covered in a future article, focused specifically on the Greeks.

Convexity

Convexity is the property responsible for the asymmetric payout potential that options contracts give to their holders. Convexity is a function of gamma. The greater the extent of directionally favourable price swings, the greater the upside of subsequent favourable price swings, and the greater the extent of directionally unfavourable price swings, the lesser the extent of losses upon subsequent unfavourable price swings.

Once an option begins moving in-the-money (ITM) at a clip that exceeds theta decay, the premium of the option accelerates in a non-linear fashion. This dichotomy is fundamental to the value proposition of options and explains why many traders prefer to stay long gamma. Downside is limited, while upside remains uncapped.

Convexity as a property is often exemplified in our daily lives. Many decisions we make are convex in nature, such as asking someone out on a date, applying for a job, or predicting BTC to 100k by December 2021. In all three scenarios, downside is limited.

If you ask someone out on a date, the worst that can happen (generally) is that they decline, but the upside is obvious. If you apply for a job and are not selected, you didn't lose much but stood to gain employment. If you predicted BTC to 100k by December 2021 on Twitter, you were off by about 50% — but it’s all good — it was just a shtick and you’ve been buying put options since BTC was at $64k. Had you been right, you would have amassed a sizable following for your predictive prowess. In essence, convexity is about non-linear returns. You risk a little while standing to gain a lot.

The Utility of Options

There is a strong case to be made that options are the most versatile means of portfolio enhancement, considering their flexibility and range of utility. The four pillars of options that make them so appealing are:

1. Leverage

2. Risk Management

3. Asymmetric Risk-Return Profile

4. Flexibility

Options are cost-efficient instruments that offer implicit leverage with minimal capital outlay. In addition to increasing upside potential, leverage allows investors to spread their capital across a greater surface area to achieve a higher degree of diversification. Moreover, options enable investors to manage risk without overspending on downside protection. The convexity of potential options payouts enables investors to risk a small amount while standing to gain a theoretically unlimited amount.

If used properly, this can lead to increased returns over the long term and portfolio resilience in a variety of market conditions. Another core feature of options is their utility in offering investors a way to dynamically express their market views. With a multitude of strikes, expiries, and underlying assets to choose from, options equip investors with everything they need to take full advantage of their convictions, insure their portfolios, or simply earn a passive income.