In traditional finance, options are a type of derivative product that allows investors to transact financial instruments such as indices at a predetermined price during a set period of time. Depending on which side of the trade the investor decides to take, there are call (buy) and put (sell) options.
Notably, the option contract does not represent ownership of an asset nor an obligation to buy/sell it. Instead, by purchasing an option an investor obtains a right to buy or sell that asset but they are not forced to do so. Thus, if an investor decides to hold an option and not exercise it until the expiry date, it will just expire with no additional costs or profits to the owner.
Options are one of the most popular derivative products, used by investors to express their prediction of the future price action. For instance, by purchasing call options investors are essentially betting that they expect prices to go up. Conversely, investors can buy put options to hedge if they believe that prices will go down.
The price of an option is derived from the value of the underlying asset. However, it is common for one underlying asset to have multiple options of different value. This is because all options differ from one another depending on the spot price at origin, the strike price and the expiry date. The asset price at which the investor agrees to buy the underlying asset through the option is called the strike price and the fee of the option contract is called the premium. The more time left on the contract, the higher the premium is going to be for both call and put options. The expiry date refers to when the option contract becomes invalid or in other words “expires”.
There are two styles in options: American and European. The fundamental differences between the two are the exercise rights date, trading closure date and settlement price.
- American-style options can be exercised at any time before the expiration date
- American index options stop trading at the close of business on the third Friday of the expiration month with a few exceptions such as quarterly and weekly options
- The settlement price for American options is the official closing price for the expiration period; all options that are in the money (an option that has intrinsic value), even by one cent, are automatically exercised unless the owner specifies otherwise. The settlement price is the regular closing price before the market closes on the third Friday, excluding after-hours trades.
- European-style options may only be exercised on the expiration date
- European index options stop trading one day earlier, at the close of business on Thursday preceding the third Friday of the expiration month
- In European options, the settlement price is not published until hours after the market opens and there is often a change from the previous night’s close and that makes holding the position overnight a large gumble.
The value of the option contract is derived from the current expectation of future price events. Hence, the higher the market expectation of a certain price level is, the more expensive an option on that strike price will be. For instance, if there are enough investors who believe that Bitcoin will go beyond the $100,000 price level by Dec 2021, the price of a call option with Dec-2021 expiry date and $100,000 strike price will be relatively expensive due to high demand. Investors that are bullish will drive the underlying asset to rise in price and as such the options will be more expensive. Therefore, investors often look at the option prices with future expiry dates to evaluate the long term price expectations of the market.
Volatility is another key factor that affects the price of an option contract. If the price action of a certain asset is expected to be volatile and has historically recorded significant fluctuations, then its future price level becomes much harder to anticipate. Options become a valuable instrument to offset uncertainty about the future by locking in an asset at a known price level (strike price).
Digital assets experience some of the largest price fluctuations, which arguably has deterred some investors from taking positions in them. However, the introduction of crypto derivatives, including options, has attracted an additional $1.3 trillion of trading volume to the market as of December 2020. Today this sector represents 55% of the total crypto market.
Options are flexible financial instruments and allow traders to gain exposure to an asset’s potential price movement with a limited downside. Given that investors are not obligated to purchase the underlying asset, the maximum loss extends to the option’s strike price only. These derivative products can be lucrative as traders can potentially buy a larger amount of the underlying asset should their predictions come true. Finally, investors use options to hedge if they believe that market prices will go down during a specific period and are generally considered low-risk compared to futures markets as they can avoid sudden price movements.
Options as a financial instrument typically are presented only to sophisticated traders. Injective is helping to change this paradigm by providing access to decentralized derivatives such as options to everyone. In this way, anyone will be able to access a plethora of financial markets and gain exposure to new ways of hedging the crypto market.
Injective is a custom interoperable layer one protocol for building powerful exchange, DeFi, derivatives & Web3 applications. Injective was created using the Cosmos SDK and is able to achieve instant transaction finality while sustaining lightning fast speeds. INJ is the native deflationary scarce asset that powers the Injective Protocol and its rapidly growing ecosystem. Injective is incubated by Binance and is backed by Pantera Capital.