Crypto Options Are Becoming Increasingly Popular
Even with the ongoing vaccination efforts, the world’s economy looks vastly different than it did a year and will likely be a hybrid of its pre-covid levels. The new financial landscape and continued uncertainty have increased investors’ curiosity towards untraditional financial assets. One such asset is cryptocurrency, which is cementing itself as a recognized asset class among major asset managers, investment banks and hedge funds. As Cryptos become more mainstream, it has given investors a chance to explore new ways to extract returns in the form of crypto options.
What are options?
Simply put, options are financial contracts that allow investors to buy or sell the underlying asset at a set price, at a future date. This allows investors to take directional bets on the price movement of an asset. For instance, investors that expect an asset price to increase can purchase a call option from which they will profit if the market price of the asset exceeds the strike price. For call options the strike price is where the security can be brought by the option holder and for a put option(an exact reverse of the call option) is the price at which the security can be sold.
Why trade with options?
With options, investors are able to gain exposure to larger positions at a fraction of the cost. For example, let’s consider buying 1000 shares of a stock at J$100. In order to do this, an investor would need J$100,000 in capital. However, with options the cost can be significantly reduced say with a J$1000 premium. An option premium is influenced by three main factors: the price of the underlying market, its level of volatility and the option’s time to expiry. Options also allow investors to gain exposure to the market’s volatility. Since the price of an option is linked to market volatility, options tend to get more expensive in a volatile market. The biggest use for options is as a risk management tool. Investors can buy put options in order to hedge their portfolio when they are uncertain about market direction. In other words, this is like buying insurance on your portfolio in order to protect it from market volatility or downward moves.
As institutional interest grows for the cryptocurrency markets, so has institutional appetite for crypto options, especially given that crypto markets are highly volatile. This allows investors to not only capitalize on the volatility but also creates an urgent need for investors to be able to diversify their strategies and hedge their positions while still getting exposure to the upside. This type of trading is not only viable for institutions as retail investors are now realizing the benefits these options offer even in the midst of global economic uncertainty. According to Trade Alert (a CBOE Global Markets company that provides real-time alerts and order flow analysis tools to institutional participants), 2020 was a record year for the options market in terms of volume traded, with 7.5 billion contracts traded. In addition, brokers such as Schwab have seen 116% increase in options being traded where it is estimated that 60% of all options being traded are from retail investors. As we make headway into 2021, major names such as Goldman Sachs have also announced expanding their crypto presence by offering options trading in Ether after recognizing a huge institutional demand.
Investors must note that centralized exchanges are better equipped to handle retail demand for options as they don’t suffer from network congestion experienced on Ethereum, leading to instant execution with lower fees. However, this does not rule out innovations that come with decentralized finance. Centralized exchanges along with decentralized finance application are working to bring more crypto currencies to the option markets and with the fallout from global pandemic expected to last until 2025, crypto currency markets are likely to remain volatile, thereby allowing investors a chance to capitalize through the use of crypto options. While cryptos isn’t a prevalent asset class locally and it is still fairly a niche asset in global markets, the expectation is that it might become an important asset class, with relevance to both retail and institutional investors locally. Therefore, it is useful to get acquainted with it from now.
Written by Jonathan Cook, Investment Strategy Analyst
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