What are Cryptocurrency derivatives? It’s simply a contract agreement between buyer and seller.
Though no one ever truly masters trading — it’s an art like medicine, not a science like engineering even despite all the graphs — chart patterns are not the final element of your training. The last lessons before Pinocchio becomes Real Boy are about a special kind of trading called derivatives.
“Derivatives,” like standard deviation, might seem like Just a Little Too Much Math. Unfortunately, the math you told your teachers you would never use in real life is vital to successful trading, and you’ll not only have to learn some new calculations, you will need to fully embrace a new way of thinking. While it will be a mental stretch at first, it’s a skill you can build with practice. To be honest, it’s actually kind of fun. And the upside can be insanely lucrative.
The term “derivative” comes from a word that we actually hear once in a while, “derive.” It’s a verb that means to come from. The value of a derivative is based on — that is, comes from — something else, generally the price of a security.
According to the Web site Investopedia, a “security” is defined as a fungible, negotiable, financial instrument that holds financial value. It represents an ownership position in a corporation, a creditor relationship with a borrower, or the right to ownership.
As is typical with the financial industry, that definition is about as clear as mud. That’s the game, after all: To couch the actual simplicity of Wall Street, where buyer meets seller and nothing more, into something complicated and intimidating.
If the general public thought finance was easy, after all, then people wouldn’t pay brokers and analysts jillions of dollars a year to explain something as simple as interest or dividends. Yet here we are. So let’s translate this into something approximating actual spoken English.
“Fungible” just means one is as good as another. Every dollar is worth 100 cents, so each is as good as another, at least for spending purposes. (As opposed to, say, collecting.) That’s fungible. “Equal” works just fine, too: Financially speaking, one share of Berkshire Hathaway might be worth more than $200,000 so ALL shares are worth the same amount at any given nanosecond.
To put it a third way, all derivatives are uniform. They’re standardized. If they weren’t, trading really would be impossibly complicated and more akin to the way collectors grade stamps than the way bankers count stacks of fungible bills.
“Negotiable” just means you can sell it. The Brooklyn Bridge is non negotiable. Your lawn mower is negotiable. We can mutually agree to a price. The rest of the definition spells out whether the asset in question is a stock, a bond or this new idea of “the right to ownership.” That final one is a derivative. It’s simply a contract (a legally enforceable) agreement between buyer and seller. The contract gives the buyer certain rights and also obligates the seller to certain responsibilities. These contracts are referred to as “options,” as in what they give the owner.
1. Types of Derivative Option
Derivative options come in two flavors, calls and puts.
A “call” option gives the owner the right to BUY a security — in this case, digital currency — at a preset price (called the “strike”) for a specified period of time. A March IBM 200 call option would give its owner the right to buy IBM at $200 per share — in 100 share lots — before the March expiration date. (These contracts are also standardized and thus fungible and thus a security.)
The question you might be asking is why in the world anyone would want to do this — to buy the right to buy something. Believe it or not, options are one thing on Wall Street that was not designed to make money. Rather, the initial idea was to mitigate potential financial risk. Options got their start in the futures market as a way to prevent people from LOSING money.
Imagine a large bakery, the kind that turns out loaves of bread by the tens of thousands every day. Put on your business person’s hat or green eyeshade and think about the invoices that must pile up on the managers’ desks. What are the big ones? Labor, to be sure. Certainly real estate and energy also, as well as inventory. Inventory is not only the finished items on hand for sale to customers, it is also the total of the inputs stored for future production.
At a bakery, one of the key supplies is flour, the price of which obviously is directly tied to its base commodity, wheat. Though all prices fluctuate, commodity prices can swing widely and in a fairly short period of time. Why? In the case of flour, the price will be affected by random (and rapidly changing) factors such as weather.
If a major thunderstorm produces hail that levels the wheat fields across a large slice of the Midwest, you can bet that the massive destruction of supply will increase the price of wheat and everything made from it, and possibly by a lot. This presents a significant business risk.
Assume a well managed bakery can operate at a 20% margin. Any increase in input prices must come directly from that slack. A dramatic increase in price could imperil the business’s prospects of continuing as a going concern, and a prudent business owner seeks a solution for how to protect against this potential spike in prices and subsequent drain on earnings ability.
How? There are at least three ways. The first is to go buy a farm and produce one’s own flour. That’s capital intensive, takes a lot of time and still doesn’t really solve the root problem — the weather could just as easily destroy that field, too. The second alternative is to buy a futures contract that will entitle you to take delivery of whatever commodity you require (or which you could sell to cover your increased costs).
This is a good, basic way to “hedge” a risk, to try to mitigate the potential for loss. But prepaying for wheat to guard against an increase in price might not be feasible. So Wall Street, which is always there to help, came up with another idea:
The bakery’s managers can buy the right to buy the wheat if and only if they decide it’s needed. There’s no legal way out of a futures contract: One party pays money, another party delivers wheat (or buys an opposite contract to “cover” it). With a call option, however, exercising your right as an owner is — wait for it — optional. The owner can either use his purview or not.
Plus it’s pretty cheap. (We’ll get to why in a little bit.)
2. Time Value vs. Intrinsic Value
Options are priced according to a formula called Black-Sholes, then the market takes over and prices are set by what buyers are willing to pay. The price of an option is composed of two elements, and it’s critical to understand both.
The first element is intrinsic value. Intrinsic value is determined by calculating the difference between the market price of the security and the strike price of the option.
Okay, so that was a mouthful. Let’s break it down.
Halliburton is trading at $50 a share. Frank owns a call option that gives him the right to buy the shares for $40. That option, like all options, covers 100 shares of stock. Its intrinsic value is the market price minus the strike price, or $50 – $40, which is $10.
The trouble is, though, that an option with $10 of intrinsic value generally will not sell for merely ten bucks. It will sell for more. The reason? Time. The option is worth $10 worth at the moment — but there will be a lot more moments in which that spread could widen. The price also could fall, of course, but Wall Street tends to assign a premium to upside potential.
That additional prospective upside isn’t free, it must be paid for. And this is known as the “time value” of an option. Intrinsic value plus time value equals the option’s price. Always.
Okay: Here is where the rubber meets the road…
An option can be described as “out-of-the-money” or “in-the-money.” An in-the-money option has intrinsic value. An out-of-the-money option does not — it only has time value. Just think about it for a quick second, and don’t overthink it. You can buy Halliburton for $50 on the stock exchange.
The right to buy the shares at $60 carries no intrinsic value unless the market price rises above the strike price — whether it goes from being out-of-the-money to in-the-money.
To put it clearly:
A call option is in the money when the market price of the security rises above the strike price of the option. Otherwise it is out-of-the-money. In-the-money options cost a lot more than out of the money options. The market — getting back to the Efficient Market Hypothesis, such as it is — prices in possibilities known in light of all available data. Out-of-the-money options cost very little because the market assigns very little probability that they will ever gain intrinsic value.
This happens, of course, to varying degrees based on immediate price proximity. If Halliburton is trading at $38, a 40 Call will be significantly more expensive than a 50 Call. The market price could move two bucks based on which way the wind is blowing — but the wind would have to reach hurricane strength for it to hit 50. Traders, to continue to metaphor, see a clear weather radar. So the 50 Call stays cheap. But one credible rumor of a takeover and all of the sudden — boom! — storm clouds on the horizon will push even the 50 Call higher.
For a put option, which is the opposite of a call, everything flips. The option is in-the-money if the market price is lower than the strike price. If it is higher, then it is out-of-the-money.
An option can also be at-the-money, just as a coin could theoretically land on its edge rather than heads or tails…
That’s the theory. Let’s see what it looks like in practice by assessing the rational reasons either side of this trade — each counterparty, the borrow a little financial jargon — would buy or sell each flavor of option.
3. Why People Buy Options
Reasons to Buy a Call
Buying a Call is bullish. You think the security’s price will go up before the option expires.
Reasons to Buy a Put
Buying a put is bearish. You think the security’s price will go down before the option expires.
Reasons to Sell (or “Write) a Call
Selling a call is bearish. You do not think the market price of the security will rise above the strike price of the option before the option expires.
Reasons to Sell or Write a Put
Selling a put is bullish. You do not think the market price of the security will fall below the strike price of the option before it expires. Thinking Things Over: Have you ever noticed how news outlets assume that a market rise is good for investors? That shows a huge lack of understanding of how financial markets actually function and what outcomes mean to various market participants. A down day across Wall Street might seem like bad news, but it’s a Godsend for traders who have shorted a security, bought a put or sold a call.
4. Basic Option Plays: Strangles and Straddles
One thing about Wall Street is that it just can’t leave well enough alone. As if options can’t be mind-bending enough, some traders love to complicate things further by using all sorts of different strategies to make money. Remember, no one can really predict whether the market will go up or down on any given day.
The smartest thing ever said about this was when a reporter cornered the financier J.P. Morgan and asked him what the market would do. “It will fluctuate,” the wise man said. And that is precisely what sophisticated options traders are hoping for.
The straddle, or “long straddle,” is a position where the trader buys a call and puts on the same security with the same expiration date and the same strike price. This presents an enviable outcome, as the upside is unlimited but the risk is finite. It is called a “long” straddle sometimes because the trader has bought the options. Long is the opposite of short.
The strangle is a variation on the straddle. The strangle entails buying a call and buying a put on the same security with the same expiration date but with DIFFERENT strike prices – both out-of-the-money. It’s a bet on big movement, but it does have limited upside.
Let’s play this one out nice and slowly: Assume a security is trading at $50. David buys a call and a put. The call’s strike price is $55 and costs $400 ($4.00 for each option multiplied by 100 shares). The put’s strike is $45 and costs $300 ($3.00 per option x 100 shares).
If the price of the stock stays between $45 and $55, the loss is the total premium paid – in this case $700. But the strangle makes money if the price of the stock moves outside the range.
So say the price of the stock ends up at $35. The call option has no value and expires worthless for a $300 loss. But it has gained value, and it is worth $700. The trader eats the loss and banks the gain and comes away with a $400 win – even though she never owned the underlying security.
At present, options trading in cryptocurrency is possible at deribit.com — a cutesy combination of the first syllables of “derivative” and the “bit” from bitcoin. This area of trading is likely to be the fastest-growing area of the financial space in the next several years, especially as the price of bitcoin soars, making it harder to buy and thus more attractive to bet on with options. Mastering trading means mastering options. The best way to do that is to refer to our Cryptocurrency knowledge and review it until it becomes intuitive. Then test yourself by checking any random stock or commodity and asking yourself how to take the fullest advantage of the direction or the volatility you anticipate.
(And, not for nothing, but if all you take away from this book is an understanding of call options, you’re in good stead to earn back the purchase price many times over. That’s because you can write – that is, sell – covered calls on the stocks you already own.
For instance, if you have 1,000 shares of Altria (a great income stock), you can add to your dividend stream with the premium earned by selling calls. If the market price exceeds your strike, you’re obligated to sell, but you can engineer the strike so that you never sell at a loss. If the price fails to rise above the strike, you keep the premium and the shares.
Say you write an out-of-the-money call four times a year and earn $0.50 a share each time. 1000 times 0.50 times 4 is $2,000 in free money. Check out your broker and investigate options. You will be asked to sign an options agreement, and while it’s not required, it is wise to take the various educational courses at the Chicago Board Options Exchange.)
Many traders also embrace options because it is sometimes seen as a less risky way to take either side of a trade without having to maintain a margin account, which is a potentially powerful and thus potentially dangerous credit instrument. (That means your broker is lending you part of the money you are betting with. All short sales take place in margin accounts, which require certain minimum capital requirements. Those requirements, if unmet amid a major market move, could force a broker to liquidate the assets in your account to collect their money. There is no extension of credit required in an options transaction: You as the trader pay the premium to buy the option, then you either resell it or let it expire.