Introduction

Options have (rightfully) earned a reputation for being complex financial instruments that are best for ordinary investors to avoid. For the most part, this reputation comes from (a) the complex math required to price them, and (b) their use as reckless gambling instruments on places like r/wallstreetbets.

In this short article I'd like to give a short introduction to options, how and why they can be responsibly used, and how Bitcoiners can do so. I am a long-term HODLer; I am not a daytrader or a gambler, and I am extremely averse to exchange and custody risk. I'm writing this article with that sort of audience in mind.

There are three main reasons that such a person would want to get involved in options:

To "yield farm" Bitcoin that is otherwise just sitting idle (while exposing ourselves to additional risk)
To "sell upside" that we don't need or want
To insure against bad market events

Believe it or not, options can be used to safely and responsibly achieve these goals, without any GUH moments or unreasonable risk.

Risk: Exchanges

This will be a US-centric article, so we will focus on using LedgerX as a trading platform. To sign up with them, go to their site and follow the instructions; the requirement is that you be a US person for tax purposes (have a SSN or EITN). If you are unsure about your eligibility, contact their support line or your own lawyer.

The difference between LedgerX and other popular options platforms are:

They are CFTC-regulated and "on the level" as much as any cryptocurrency trading platform can be
They are fully collateralized: there is no margin available and cash is actual cash, not USDT or any other proxy

This means that LedgerX users are exposed to far less exchange risk than their peers, as no rapid price movements or other market activity will threaten the exchange's solvency, nor are they incentivized to cause weird market activity in order to liquidate their customers. You also have assurance, as the holder of a contract, that the cash or Bitcoin promised to you actually exists.

On the other hand, as a writer of contracts, you are required to put up collateral and keep it on the platform for the duration of the contract. LedgerX uses BitGo as its custody provider.

Another source of risk is LedgerX's support of Ethereum. Ethereum's consensus rules are not publicly verifiable in the same sense that Bitcoin's are, and Ethereum has a long history of blockchain forks with very little (or no) forewarning. LedgerX has not provided any guidance as to how Bitcoin users will be protected when the Ethereum network inevitably causes them a solvency crisis.

~~Conversely, unlike other exchanges, LedgerX supports only Bitcoin and Ethereum and has no plans to become a shitcoin casino so this source of risk is actually much less at LX than elsewhere.~~ Update 2022-05-15: Further, LedgerX has been acquired by FTX, whose CEO is an outspoken anti-Bitcoin shitcoiner, which should concern you. To the best of my knowledge there is no better platform, which really says something about this industry.

Do you own research. Assess your own risk.

Risk: Trading

Conventional investment advice is that you should "buy and hold" securities that you believe have sound fundamentals and which will grow over time, and that you should never try to "time the market" or daytrade.

Unfortunately, options are contracts that have explicit dates on them, so any interaction with them will be "timing the market" in some sense, and because these dates are in the near future, you will be forced to trade at least every year or two, likely more frequently. Further, unlike most ordinary securities, options may experience rapid price swings and their prices may even rapidly go to zero.

In other words, you can and will lose money, depending on your options trading strategy, and you should never trade any instrument whose behaviour you do not understand.

I am not your lawyer or your broker or anyone else with any contractual obligation to have your best interest at heart. This is investment advice but if it goes wrong on you then you are on your own.

How to Trade Options

Ok, with the introduction out of the way, let's talk about how to actually trade options. First, these give a quick run-through of the math.

The Greeks, and What Is An Option

First, let's quickly define an option. An option is a financial derivative (contract) which gives the holder the right but not the obligation to make some sort of trade. For our purposes, there are two kinds of options

A call option gives the holder the right (but not obligation) to buy 1/100th of a Bitcoin at a specific date (the expiry) at a specific price (the strike).
A put option gives the holder the right (but not obligation) to sell 1/100th of a Bitcoin at a specific date (the expiry) at a specific price (the strike).

Options are identified by their strike, expiry, and whether they are a call or put. Typically they are referred to just as "contracts" when the context is clear, as in "Those $50000 year-end calls are looking pretty cheap. I bought 500 contracts this morning."

When an option hits its expiry date, which will always be 4PM New York time on a Friday, the holder has two choices:

He may exercise the option, meaning he buys the underlying (for a call) or sells it (for a put) at the strike price
He may let the option expire worthless, meaning he does not do this.

This is always a straightforward choice: if Bitcoin is worth more than the strike, you want to exercise a call (as you're buying it cheaply) and not exercise a put. Conversely if Bitcoin is worth less, you want to exercise a put (selling it expensively) and not exercise calls. In the case that an option is worth exercising it is called in the money; otherwise it is out of the money. If the spot price is very close to the strike price you may say it is at the money meaning that it may flip between in/out of the money at a moment's notice.

One final piece of terminology: LedgerX options are European options, meaning that they can only be exercised on their expiry date. Many options on other markets are American options which can be exercised at any time. For a non-dividend-bearing instrument like Bitcoin, there should be no price difference between the two of them, but using European options makes accounting simpler for option sellers.

Options on LedgerX have units of 1/100 BTC, but the displayed prices are for 100 contracts (1 BTC). This can be confusing, so keep an eye out for it. Even more confusingly, ordinary equities typically have options with units of 100 shares, meaning that the 100x multiplier goes in the opposite direction. If you are searching for general options trading advice, and you should, you will run into this disconnect.

The price of an option varies with the price of Bitcoin (which is the underlying of these contracts), in a somewhat-complicated way, according to something called the Black-Scholes equation. If, like me, your graduate-level probability class left Black-Scholes as an optional unit that you skipped, here's a quick summary:

Black-Scholes models the price of Bitcoin as a uniform random walk which increases on net by something called the "risk free rate" (the return on a "risk free" instrument, such as a 10-year US treasury bill) (conveniently this is basically 0 nowadays so we can forget about it) and which assumes that instantaneous price changes are otherwise random.
When the price of Bitcoin goes up, the price of calls goes up and of puts goes down...
...by a proportion called the delta of the option. You can also think of the delta as the probability that the option will wind up in the money. This is a subtly incorrect interpretation though so be careful.
When the volatility of Bitcoin's price increases, so do the price of both calls and puts. This is denoted by the letter sigma but usually said out loud simply as "volatility".
As options near expiry, their price decays, by a quantity called theta, which is usually given in dollars per day.

You can find many Black-Scholes calculators online, where you can input the price of Bitcoin, the option data (strike price and expiry), and your estimate of volatility, and it will give you the other Greeks as well as the fair price for the option in the B-S model.

Typically you will run Black-Scholes backward, by giving it the price (best bid or ask) of an option and having it output an "implied volatility" (IV). Generally, when trading options, the IV is what you care about, and represents the price of the option in an intuitive sense.

For normal assets, IVs are typically somewhere around 10 or 20% unless something dramatic is happening. For Bitcoin, IVs seem to be 60-80% on boring days and 100-200% on exciting ones.

Strategy 0: Gambling

Before discussing two legitimate options strategies (selling upside/downside and hedging), let's cover the typical r/wallstreetsbet use of options.

As an example, at this moment it is August 9th and the price of Bitcoin is $46000. On LedgerX, I can buy a call option expiring August 27th (in 18 days) with a strike price of $75k, for $138/coin or $1.38/contract.

If Bitcoin exceeds $75k on August 27, and I'm holding such a contract, then I get to buy Bitcoin at $75k and then immediately sell it, pocketing the difference. If Bitcoin's at $80k, that's five thousand dollars a coin -- and you can be sure that if it goes past 75k, it'll go past 80k too. So basically, if I were to buy one of these contracts, I'd be making the following bet:

If Bitcoin fails to hit 75k on August 27, I'm out $1.38 per contract.
But if Bitcoin exceeds 75k, by a lot, then I'll pocket $50 per contract (or more ... the potential gains are actually unlimited)

So really, if I skip all that boring Black-Scholes nonsense and just make up one number -- the probability that Bitcoin will blow past $75k -- then I can think of these calls as lottery tickets.

And if I were to buy a call expiring even sooner, or with an even higher strike price, I could get even more cheap lottery tickets.

Of course, with very high probability Bitcoin will not hit this magic number and my $1.38 will simply evaporate. This is the way that r/wallstreetsbets users treat options, and it is not smart.

Strategy 1: Yield Farming

A semi-legitimate options strategy that we'll discuss is essentially the opposite of the r/wallstreetbets strategy. Here you write a far out-of-the money option and sell it to somebody who is gambling.

To do this, let's say that the IV of various options being traded is around 90%. (We can determine this by looking at the best bid/ask of a few popularly-traded options using a Black-Scholes calculator.) We can bump this up a bit, to say 150%, and look at the resulting price of our $75k Aug 27 call: $214.

If we have 1 Bitcoin laying around, we can then put an ask in for 100 contracts of the Aug 27 $75k call at $214, and wait for somebody to come by who thinks "lottery tickets for $2.14 a contract? What a steal!". If somebody bites, and on LedgerX there's a good chance they will, then in the high likelihood that Bitcoin fails to hit $75k, you just pocket their money and repeat next week.

This strategy has much better odds of working, because now you are "the house" rather than "the gambler", but it is ultimately still gambling.

In traditional equities there is an expression for this: picking up pennies in front of a steamroller. This is because you can pretty reliably earn small amounts of money each month (or week) by doing this, until one day Bitcoin actually does triple in price over the course of a month and you're forced to sell at a bad price.

On the other hand, because of the immaturity of the Bitcoin market and the presense of "moonboys" buying long-shot options at crazy prices, these pennies can add up, and during high-volatility times it may be worth using this strategy.

Strategy 2: Selling Upside

This next strategy is quite similar to the "picking up pennies in front of a steamroller" strategy, with two important differences, which make it the first strategy that I would actually recommend:

You choose a strike at which you'd need to sell your coins anyway (to balance your portfolio)
You typically choose a much further out expiry date, to maximize your immediate gains

Let's illustrate this with an example. Suppose that my portfolio is 90% Bitcoin today, when it's $46k, and if it were to hit $75k, then my portfolio would be 95% Bitcoin -- an amount that my advisor tells me is so reckless that he will be forced to hire three ghosts to visit my bedchambers and harass me into selling 5 coins.

This means that any upside to Bitcoin beyond $75k is actually inaccessible to me. If it hits $200k, sucks for me because I'll have sold at $75k. In other words, there is potential upside which is worthless to me, and that I'd make some free money if I could sell.

In fact, call options are exactly the instrument to represent potential upside! Consider what happens if I sell 500 contracts of a Dec 31 $75k call option:

If Bitcoin goes past $75k, I'll be forced to sell 5 coins at $75k, exactly as I was planning to anyway. But I also get to keep the price of the original option (called the premium).
If Bitcoin does not go past $75k, I won't sell the 5 coins, exactly like I was planning not to. Now I keep the Bitcoins and the premium.

What's cool about this strategy is that for long-term options, even at non-ridiculous IVs, prices can be pretty favorable. For example, on LedgerX right now there is an open bid for 288 $75k Dec 31 calls at $2810. This is an open bid -- I can sell 2.88 BTC worth of this right now and pocket the $8092 without even waiting for a moonboy.

Currently the Bitcoin price is $46k, so $2810/coin is 6%. In other words, I can get a 6% yield over the course of 5 months (so 15% annualized) on my Bitcoins literally for free, by selling upside that I didn't want anyway.

I can do the IV calculation on this: at a price of $2810 the IV is 80%. So the person sitting on this bid is bidding a little high but not too crazily. He may be using Strategy 3 below and insuring himself against FOMO.

If I spent a month or two on LedgerX, I can sell a lot more than 2.88 BTC's worth of these options, so don't be turned off by the low numbers here. This is just an example of what could be executed right now even if you didn't have the patience to finish this sentence.

By the way, you can do the same thing with puts -- maybe if Bitcoin fell to $25k then you know you'd buy a dozen coins. In this case, you can sell $25k puts, pocket some money now, and worst case be "forced" to buy BTC at $25k like you were going to anyway.

Strategy 3: Buying Insurance

Our final strategy is in some sense the inverse of the "selling upside" strategy, and is actually a way to reduce the risk of holding Bitcoins. The idea here is that we want to protect our portfolio from extreme market events, whether that be an extreme price jump (for a nocoiner) or an extreme crash (for somebody whose whole portfolio is Bitcoin).

The premise is pretty simple: you set a maximum price at which you want to be able to buy Bitcoin, and buy a call option with that strike price, or you set a minimum price at which you'd sell and you buy a put option at that strike.

Let's do an example: say I have 20 BTC, currently worth $960k. If Bitcoin were to crash to $25k, then I'd have only $500k and would be worried about my ability to retire comfortably. I really don't want this to happen.

Well, currently Dec 31 $25k puts are moving at around $3000, an IV of 124% (ouch!). If I were to buy 20 Bitcoins' worth of these -- and bear in mind on LX that this could take me a few weeks or months, because not enough people are using Strategy 2 who will take the other side of this trade -- then I'd be assured that I could always sell my BTC for at least 25k, no matter the price. Though come December, when these options expire, I would need to buy more to keep my insurance.

This is pretty steep, at 6.5% of the value of your coins (16% annualized) just for peace of mind. But Bitcoin has crashed pretty hard before, and if a $25k crash would mean my losing my retirement, or my company going insolvent, maybe it's worth it.

The opposite of this is also possible: maybe you are a no-coiner and will feel really awful when Bitcoin blows past $100k. Well, you can buy a $100k call right now for $2260 (an IV of 100%, ouch), and if this scenario comes to pass, you'll have your ticket to get on the train to the moon, and worst case you're only out $2260.

This strategy is known as hedging and is a common tool to reduce risk when managing a portfolio. Unfortunately, in the Bitcoin world, when buying options you are competing with moonboys for calls and nihilist millenials for puts, which makes this a bit expensive. But it still may be the right thing to do.

Conclusion

I meant this to be a quick 15-minute read but now it's over 3000 words. I apologize for that but hope that it's been a reasonably accessible and useful introduction to the hows and whys of options trading on Bitcoin.

We discussed four options strategies, the first two of which were basically just gambling but the last two of which were legitimate tools that a smart and risk-averse trader may want to use to manage their portfolio. Bear in mind that there are many many options strategies and this only scratches the surface -- we didn't even mention reasons to trade in-the-money options, for example.

A curious thing is that traders using Strategy 2 will be taking the other side of trades with traders using Strategy 3 -- and both are doing the right thing according to their portfolio goals. This means that you shouldn't worry about trying to bring more people to the platform who might compete with you; there is a good chance that you'll directly benefit from others joining the platform. And of course, there is a 100% chance of you benefiting indirectly, because more traders means more volume and more liquidity.

Please, tell your friends.