Options will be vital for bitcoin trading

January 23, 2018 04:00 PM

 With volatility over the last two years at record lows traders have been itching to trade something that really moves. Bitcoin definitely fits that description. On the first day of 2017 bitcoin traded above $1,000 for the first time since January of 2014. The highest price for bitcoin at the time was 1,216.70 in 2013. By June 5, 2017 the price more than doubled to 2,874.00. On Nov. 12 it was trading at $5,426.

In a little over three weeks later it has crossed the $16,000 barrier. This is making the dotcom bubble look tepid by comparison (see “Exponential growth,” below). 

On Dec. 10, 2017 at 5:00 pm CST the Chicago Futures Exchange (CFE), a branch of the Cboe Global Markets (Cboe), will launch a bitcoin futures contract under the symbol XBT. A week later CME Group (CME) will launch its bitcoin futures contract. The margin will be 35% as opposed to a 5% margin for S&P 50 futures.   

A date has not been set for the trading of listed options on either exchange. The initial pricing of the options will be a tough nut to crack.  The pricing will be based on past performance and future expectations. Eventually, the order flow will have the greatest effect on pricing. 

Let’s look at Facebook (FB) as a template for how to trade options on bitcoin. The FB Jan. 19, 2018 180 calls closed at 5.25, while the 180 puts closed at 4.60 with 42 days until expiration. The straddle implies that the range over the next 42 days will be $170.42 to $189.87.  If that range occurred during that period of time the historical volatility (HV) would be 21%. That is how you arrive at implied volatility. The higher the price that traders are willing to pay for options, the greater the future range they expect. 

Now let’s look at the “greeks.” Delta measures the percentage chance that an option will be exercised if it is kept until expiration. Call deltas are positive since a long call represents the possibility of becoming long stock or futures. Put Deltas are negative since a long put represents the possibility of becoming short stock or futures. With FB at $180.27 the 180 calls have a 51 Delta and the puts have -49 Delta. If the 180 straddle is bought 20 times the net Delta would be 40 Deltas. That is the equivalent of being long 40 shares of FB. 

Gamma measures the change in delta over a one-point move. Long options have positive Gamma. Short options have negative Gamma. The Gamma for the 180 calls and puts is 3. The long straddle has a positive Gamma of 120 if the straddle is bought 20 times. If there is an upward move of 1.00 the new Delta is 160 ((1X120) + 40). If you’re not taking a directional opinion you can sell 200 shares to pare your Deltas down to -40. If FB retraces back down to $180.27 the shares can be brought back for a $200 profit. If FB then drops to $178.73 the new Delta is -140 ((-1.5X120) +40). If you buy 100 shares at $178.73, you have pared the Deltas to -40. If FB moves back up to $180.27 you can sell your shares for a $150 profit.  That’s a total profit of $350. 

Theta measures the erosion of time value in the option premium over one day’s time. Long options have negative Theta while short options have positive Theta. The Theta for the 180 calls and puts is 6. The Theta for the entire position is -240. Options are a wasting asset. You would be slightly profitable on your stock trading ((-240X7)/5=336); 350 is greater than 240 but you can’t trade stock on your position over the weekend. Theta also expands exponentially between now and expiration. This process is referred to as “Gamma scalping.” 

Vega measures the effect of a one-point move in implied volatility. Long options have positive Vega while short options have negative Vega.  The 180 calls and puts have a 25 Vega. The FB straddle would have a profit of $2,000 if the implied volatility rose two points and a $2,000 loss if the implied volatility dropped two points. Vega shrinks as time goes by since it is a measure of time value. 

This type of position best fits bitcoin, considering its massive volatility. The Theta will be huge but the movement should be greater than the decay in the options. The other danger in this position would be a sudden drop in implied volatility. 

Despite it’s the growing buzz surrounding all things bitcoin and cryptocurrencies, there is no telling how futures on bitcoin will fair. However, given the volatility surrounding the instrument—and the unknown aspect of its ultimate value—the ability to create positions with well-defined risk parameters, as is only possible with options, will be a benefit for those brave enough to trade it.   

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.