Options contracts are a type of derivative that allows an investor to make speculative or hedging decisions with a flexible exercise price and expiry date. Futures and perpetual swaps are the dominant forms of derivatives in the crypto market, but options are making a lunge for the crown. As more sophisticated speculators foray into crypto, options will see growth beyond futures and swaps.
At its heart, options contracts allow investors to choose a price and expiry date along with either the option to buy or sell a pre-determined amount of the underlying instrument.
Simply put, a 2 BTC call option with a strike price of $11,000 and an expiry date of May 31, 2020 means that the holder has the option, but not the obligation, to buy 2 BTC at $11,000 on or before May 31, 2020 (depending on the style of option).
Futures, on the other hand, merely offer a singular standardized contract that everybody trades. In a relatively illiquid market like crypto, options end up splitting liquidity between various expiry dates and strike prices. The standardization of futures allows for more liquidity to accrue to a single type of contract, based only on expiry.
As the market grows, liquidity is guaranteed. An increase in options liquidity is also guaranteed because more growth and more underlying spot liquidity lead to more investors entering the market.
In the stock and commodities markets, options are dominated by financial institutions looking to either hedge an existing position or speculate on price movements with capital efficiency. There are retail traders as well, but they do not significantly affect market liquidity.
For example, a March-end expiring BTC $10,000 strike price call option on Deribit has a premium of $1,970. This means, so long as BTC price is above $11,970 on the date of expiration (Mar. 27, 2020), an investor will profit. Capital efficient and flexible strike prices.
The Bitcoin options brigade has seen commendable traction in 2019, with Deribit dominating volumes and CME slowly getting itself to a nearby plateau for institutional investors. As more hedge funds open up in the space, and more existing financial giants decide to speculate on the Bitcoin market, we will see options gaining more traction than futures, and much more than perpetual swaps.
In all honesty, perpetual swaps are not a very efficient instrument and are a retail-focused product thanks to the simplicity of execution. These products will continue to dominate the retail market but will be dwarfed when the big boys enter the playing field.
Physically settled and cash-settled will see a battle in the near future. It is too early to tell which of the two will be favored, as it all boils down to Bitcoin’s long term sustainability and institutional perception. However, derivatives like options will also see sustained traction in the event that Bitcoin truly becomes a medium of exchange.
If Bitcoin becomes an MoE and volatility still runs rife, derivatives will give merchants the ability to hedge price risk and keep a standard settlement price.