A Primer On Options
Skip to the next section if you are familiar with options.
Stay if you find the terms "Put", "Strike", "in-the-money" unfamiliar.
Options
An options contract is a buyer-seller agreement where the buyer gains the right to buy or sell an asset at a set price (strike) and time in the future (expiry), without being obligated to do so.
Essential Parameters
- Underlying Asset: The asset that the buyer has the right to buy or sell. Eg: BTC.
- Strike Price: The set price.
- Expiry Time: The set time in the future.
- Type: Call or Put.
- Call: The buyer has the right to buy the underlying asset at the strike price.
- Put: The buyer has the right to sell the underlying asset at the strike price.
- Currency: The currency in which the asset is priced and in which payment is made.
Note that on some traditional options platforms these may be different. Volorca uses the same currency for both pricing assets and making payments.
We will use USD($) as our currency in the following examples.
Call Options
Example: Current price of BTC is $30,000. Buyer B buys 1 Call option from Seller S with a strike price of $32,000 and expiry time of 1 week.
- If the price of BTC is $35,000 at expiry, B will exercise the option and buy BTC from S at $32,000. B may immediately sell this BTC for $35,000 on the market, gaining $3,000 in the process.
- If the price of BTC is $28,000 at expiry, B will give up the right to buy BTC from S at $32,000, since they can simply buy BTC at a cheaper price of $28,000 on the market.
In general, the overall profit/loss for buyers and sellers of CALLS is as follows.
| Side | Price of Asset at Expiry < Strike | Price of Asset at Expiry > Strike |
|---|---|---|
| Buyer | 0 | Expiry Price - Strike (profit) |
| Seller | 0 | Strike - Expiry Price (loss) |
This is a simplified table and we will look at how the seller can benefit in the Premium section below.
Put Options
Example: Current price of BTC is $30,000. Buyer B buys 1 Put option from Seller S with a strike price of $28,000 and expiry time of 1 week. Keep in mind that a Put option means buyer B has the right to SELL BTC.
- If the price of BTC is $25,000 at expiry, B will exercise the option and sell BTC to S at $28,000. B may proceed like this: buy BTC at $25,000 from the market, then exercise the option and sell it to S at $28,000, gaining $3,000 in the process.
- If the price of BTC is $32,000 at expiry, B will give up the right to sell BTC to S at $28,000, since they can simply sell BTC at a higher price of $32,000 on the market.
In general, the overall profit/loss for buyers and sellers of PUTS is as follows.
| Side | Price of Asset at Expiry < Strike | Price of Asset at Expiry > Strike |
|---|---|---|
| Buyer | Strike - Expiry Price (profit) |
0 |
| Seller | Expiry Price - Price (loss) |
0 |
This is a simplified table and we will look at how the seller can benefit in the Premium section below.
Terms: ITM, OTM
ITM : In-the-money
OTM : Out-of-the-money
| Option Type | Current Price of Asset < Strike | Current Price of Asset > Strike |
|---|---|---|
| CALL | OTM | ITM |
| PUT | ITM | OTM |
The buyer will see a profit if the option is ITM at expiry.
Terms: LONG, SHORT
Buyers of an option are said to be LONG the option and sellers are said to be SHORT the option.
| Option Type | Buyer | Seller |
|---|---|---|
| CALL | LONG | SHORT |
| PUT | LONG | SHORT |
Premium
There is a cost to buying an option. This is called the premium. In order to hold a LONG position in the option, the buyer must pay the premium to the seller.
The overall profit/loss for buyers and sellers is thus as follows.
| Side | Option Expires OTM | Option Expires ITM |
|---|---|---|
| LONG (buyer) | - Premium (loss) |
[Absolute difference in Expiry Price and Strike] - Premium (profit if the difference is greater than premium, loss otherwise.) |
| SHORT (seller) | Premium (profit) |
Premium - [Absolute difference in Expiry Price and Strike] (loss if the difference is greater than premium, gain otherwise.) |
Cash Settlement
Rather than requiring both buyers and sellers involved in a purchase to buy or sell the underlying asset both in the market and between themselves, an options contract can be structured in such a way that it pays out the difference between the strike price and the price of the underlying asset at expiration in the specified currency.
Eg. A CALL option with strike $30,000 and price at expiry $35,000: The SHORT (seller) will pay $5,000 to the LONG (buyer).
Eg. A CALL option with strike $30,000 and price at expiry $25,000: No payment is made at expiry. Bear in mind that the LONG (buyer) would have already paid the SHORT (seller) a premium when the buyer bought the CALL option.
Eg. A PUT option with strike $30,000 and price at expiry $25,000: The SHORT (seller) will pay $5,000 to the LONG (buyer).
Eg. A PUT option with strike $30,000 and price at expiry $35,000: No payment is made at expiry. Bear in mind that the LONG (buyer) would have already paid the SHORT (seller) a premium when the buyer bought the PUT option.
No underlying asset is transferred in a cash settlement.