Trading has always been part of the cryptocurrency world. Crypto believers anticipate a future when digital assets will be as widely used as euros and pounds, but today, the smart money is investing.
It’s easy to invest in crypto. Visit an exchange, examine the prices, and make a purchase. When the price of the crypto goes up, you can sell it and pocket your profits.
It is also possible, at some exchanges, to invest in crypto derivatives – financial instruments that are based on the price of cryptos but allow you to invest with less risk. The two most widely traded crypto derivatives are options and futures.
How Crypto Options Work
When you purchase an option, you have the right – but not the obligation – to trade the underlying asset at a specified price at a later date. The price is called the strike price, while the deadline is called the maturity date.
The value of a crypto option is derived from the value of the underlying currency. Options trading is therefore risky, especially for traders with less market experience. But as we shall see, it is less risky than investing in crypto directly.
Options come in two flavors: calls and puts.
How Call Options Work
Here’s a simple example to illustrate how call options work. We’ll use an imaginary cryptocurrency called SurlyCoins, which are currently selling for €1,300.
If you believe the price of SurlyCoin is going to rise, you might purchase a call option for 10 SurlyCoins with a strike price of €1,500 and a maturity date one month from today. The call option gives you the right to purchase the coins at the strike price. In this case, you have purchased the right to buy 10 SurlyCoins for €1,500 each in 30 days.
You buy the option from an exchange. Let’s say this option costs €100. That’s the option price.
Good news! You were right about SurlyCoin. On the maturity date, the coins are selling for €1,700 each. You have purchased the right to buy 10 SurlyCoins – a €17,000 value – for €1,500 each, a total of €15,000. Your profit on the 10 SurlyCoins options contract is, therefore, €2,000 minus the €100 you paid for the option. The exchange transfers the €2,000 to your account.
That’s what “call” options are all about. You make money if the value of a SurlyCoin rises above the strike price.
You don’t actually pay €15,000 and get 10 SurlyCoins. Most exchanges that handle crypto derivatives settle options and futures on a cash basis. They imagine that you purchase the 10 SurlyCoins for €1,500 each and immediately sell them at the market price of €1,700. The exchange puts the profit in your wallet. You never actually own the SurlyCoins.
If the price of a SurlyCoin at the maturity date was €1,200, you would choose not to exercise the option. You wouldn’t purchase 10 SurlyCoins at €1,500 each. With SurlyCoin options contracts, your losses are limited. The option would expire unexercised and you would lose only the €100 you paid to purchase it.
How Put Options Work
If you think the price of SurlyCoins will drop, you could purchase a “put” option, which gives you an opportunity to sell the commodity at the strike price.
For example, you could spend €100 on a put option to sell 10 SurlyCoins at a strike price of €1,000 in 30 days. If the price is €700 on the maturity date, your profit is €300 per SurlyCoin minus the €100 you paid for the option – €2,900. That’s a good way to make money in crypto when the market is falling.
If the price of a SurlyCoin rose to anything above the €1,000 strike price, your option to sell SurlyCoins for €1,000 would be worthless. You would let the option expire without exercising it and sustain a €100 loss – the price of the option.
European and American Options
The transactions described here are European-style trades. The options are exercised (or expire) on the maturity date. Most crypto exchanges use this system. But a few have implemented American-style options, in which options can be exercised at any time before the maturity date. You need nerves of steel with American-style options because you will face the temptation to cash out even though your profit might increase – or evaporate – if you wait a day or a week. That makes options trading a high-anxiety pastime.
How Crypto Futures Work
Futures are similar to options except that the sales must take place on the strike date.
For example, you might buy a futures contract that allows you to purchase 10 SurlyCoins at today’s trading price – €1,000 each – in 90 days. This is a great strategy if you believe the price will rise. If the price is €1,300 on the maturity date, you will earn a €3,000 profit – minus the price of the contract, of course.
But futures are risky. If the price of SurlyCoins falls to €900, you are still obligated to purchase 10 of them at €1,000 each on the strike date. You will pay €10,000 for €9,000 worth of SurlyCoins. That’s a loss of €1,000. And to add insult to injury, you must still pay for the futures contract.
Futures are also involved in short selling, which is a way to profit when a commodity’s price is dropping. Investors describe it as a way of betting against the market.
If you believe SurlyCoin’s price will drop, you could purchase a futures contract to sell 10 SurlyCoins for €1,000 each. If the price has dropped to €800 on the maturity date, you’ll enjoy a €2,000 profit.
Like options, futures contracts are generally settled on a net-cash basis. You don’t actually buy or sell the SurlyCoins on the maturity date. You get the profit or loss without ever owning the crypto.
The Bottom Line
Crypto derivatives like options and futures allow you to invest in the cryptocurrency market without actually owning any coins or tokens. They can be a good way to capitalize on market volatility and minimize risk.