Options trading is a popular way to earn money in the financial industry. It allows traders to speculate on the future price of various assets. Options are essentially contracts that use an underlying asset. Traders can then bet on the future price of the asset. They speculate if it’ll go up or down, by how much, and when.
With that said, there are two types of options — put options and call options.
In this article, we'll focus on exploring put options. Understanding this type of financial instrument can be priceless to new traders who aren’t yet comfortable with shorting but see further downside for a specific coin or token.
TL;DR
Put options are contracts that let you sell an asset at a specific price.
Puts are typically used to hedge against a position or rake in gains from significant price declines.
Trading put options can be complex to understand and involve risks like time decay and IV crush.
Puts are vastly different from call options and short selling, but serve similar purposes.
Considerations when trading put options include deciding on specific strike prices, expiration dates, and premiums.
What is a put option?
Also called 'puts', put options are financial derivatives that offer the buyer the option to sell a specific amount of the underlying cryptocurrency at a set strike price within a defined time period prior to the contracts' expiry date. What's worth highlighting is that the buyer of the put option isn’t obligated to sell, but may exercise their right to sell. That right is defined by the conditions of the contract.
Put options are essentially the opposite of call options, which provide their owners with the option to buy the underlying asset, such as a coin or token. Like puts, calls have premiums that vary based on their expiration dates and strike prices. Unfortunately, this basic explanation only scratches the surface. To learn how to trade puts on a more strategic level, we need to understand the mechanics behind put options.
Puts explained: how does a put option work?
Put options allow you to sell the underlying asset, such as cryptocurrency, stock, or something else of value. With options, the trader has no obligation to buy or sell. This flexibility is ultimately what makes them popular.
Puts are in the money (ITM) when the asset’s last-traded price is below the strike price of the put contract when the expiration date arrives. From here, put buyers have the choice to exercise their right to sell the asset at the dictated strike price and reap the gains that comes with the price depreciation of an asset.
If the put contract expires out of the money (OTM), where the asset’s last-traded price is below the strike price of the put contract when the expiration date arrives, the put expires worthless.
How do put options make money?
The way put options make money is fairly simple. Let’s assume that a crypto options trader purchases a put option for ETH for a premium of $80. Let’s also assume that the strike price for the contract was $2,000. If the underlying asset’s last-traded price slumps to $1,900 at the time of put expiry, then the put will be considered ITM and be worth $100 at expiry. Discounting the original payment of $80 for the put option, the trader gets to keep $20 as pure gains.
Conversely, if the price of ETH trades at $2,100 at the time of the put contract's expiry, then the put expires worthless. In that case, the crypto options trader would see a maximum loss of their original $80 premium.
Advantages and disadvantages of trading put options
Advantages | Disadvantages |
|---|---|
Easy way to trade for downside gains | Time decay |
Risk mitigation | Risk of IV crush |
Flexibility of crypto options strategies | Complexity |
Transaction costs |
Advantages of trading put options
Easy way to trade for downside gains
The greatest advantage of buying put options is the potential for unlimited gains when the price of the underlying coin or token falls. If you’re predicting a massive near-term slump, trading put options may be ideal since they offer leveraged exposure on the short side for specific coins or tokens while only requiring a small upfront premium.
Risk mitigation
Another plus point of buying puts is that they serve as insurance for your underlying spot holdings during market drawbacks. Since puts give you the option of selling at a specific strike price, if the puts end up ITM, you can opt to exercise the put option and sell your asset at that specified strike price. This ultimately lets you hedge with options against market corrections while maintaining your exposure thanks to your long holdings.
Flexibility of crypto options strategies
Trading put options can be influential towards various different trading goals and risk management, since options strategies involving puts and calls help to limit risk while giving exposure to the crypto market. With crypto option strategies like strangles, you can take advantage of any spikes in implied volatility (IV) and reap the gains.
Disadvantages of trading put options
Time decay
Also known as the Theta portion of the Option Greeks, put options lose value over time, especially as their expiration date approaches. This is known as time decay. If the underlying asset’s price doesn’t decline significantly before expiration, the put option may expire worthless.
Risk of IV crush
Put options become more expensive when IV is high as more crypto options traders begin to bid up the prices of puts in the expectation of a near-term catalyst causing some form of volatility. After the catalyst, this will likely result in a crash in IV, which can lead to a significant loss in the premium value of the put option.
Complexity
Understanding and effectively trading put options requires a solid grasp of option pricing theory, risk management, and market dynamics. This can be challenging for new or inexperienced crypto options traders.
Transaction costs
Buying and selling put options involve transaction costs, such as commission and fees. These costs can erode gains, especially for repeated and rapid options trades.
Put options vs call options
So far, we've explored the world of put options. Now, let's delve into the opposite side of the spectrum: call options. Unlike puts, which give you the right to sell an asset at a specific price, call options grant you the right to buy. Both types have an expiration date and require a premium.
While they share similar risks, their strategies are reversed. Both require the underlying asset's price to reach a certain level and move beyond it. However, price direction is key here: puts benefit from a price decline, while calls benefit from an increase. The magnitude and timing of this price movement also play crucial roles in determining the performance of your trade.
Put options vs short selling
Another alternative to puts is short selling. This strategy is often referred to as "shorting" by experienced crypto traders and involves selling an asset you don't own. Essentially, you're betting that the price will decline. Unlike puts, short selling involves borrowing the asset at a higher price, selling it immediately, and then buying it back at a lower price to return it. This creates a gain from the price difference.
One key distinction between puts and short selling is the obligation to buy the underlying asset. With puts, you have the right but not the obligation to sell. In short selling, you're obligated to buy back the asset to return it.
While both puts and short selling can be used to make gains from a declining asset price, they share the risk of potential losses if the price rises unexpectedly. Given the long-term upward trend in crypto markets, these strategies are generally considered short-term tactics.
An example of put options trading
Let’s now explore a trade you could consider taking if you’re bearish and want to learn how to short Bitcoin. After doing some basic technical analysis by referring to fibonacci retracement levels and the relative strength index (RSI) indicator, we can see that Bitcoin is approaching the 0.618 golden ratio Fibonacci retracement level. Meanwhile, the RSI is 63 and is quickly approaching the overbought level. Based on these two factors, it might hint that a possible near-term pullback is coming.
To capitalize on this short-term correction, we can take a look at the BTC options chain and consider buying BTC puts that are two weeks to expiry. Strike price wise, we can consider a pullback to the $61,000 level since this is around the 0.5 retracement level. This would cost you about 0.0218 BTC in premiums for the specific Bitcoin put contract. If this OTM put contract ends up ITM as Bitcoin prices crash to $61,000 in two weeks time, you’ll be able to reap a tidy sum of gains since you'll now have the option to sell one Bitcoin at $61,000 should the price plunge further.
Final words and next step
Traders worldwide use puts to anticipate price declines in various assets. As such, for newcomers to options trading, understanding puts is crucial. Puts can effectively serve as a hedge for those already holding a specific asset and double as a way to speculate on price drops. This versatility makes put options a valuable tool for traders across different markets. However, like any form of trading, dabbling with put options comes with risks. The most significant is the potential for an unexpected market turn. If your prediction is incorrect, you could incur losses. Fortunately, the lack of obligation to exercise a put option limits your potential loss to the premium paid.
Interested in how you can be on the opposite end of a trade? Check out our guide to selling cash-secured puts. Alternatively, for a more in-depth take, read our take on executing put call parity arbitrages.
FAQs
Put options are contracts that give the right to sell an asset at a specific price.
Applications of put options range from hedging positions to locking in gains from significant price declines.
Risks of trading put options include time decay, risk of IV crush, and early assignment.
If you're new to trading put options, you may consider trading put options when you expect price declines or want to hedge an existing long position against downside risk.
While it's ultimately up to your risk tolerance, you're free to choose a strike price and expiration date that aligns with your trading-related goals and time horizon.
