Zeta 101: What’s an Option?
Options and their possibilities
Options are vehicles for savvy crypto traders to make bets on price, volatility, interest rates, tax and many more factors. Options are also an investor’s best choice in order to lock in profits, hedge their portfolio and maximise long-run returns. In the right hands, an option is the ability to take on the risk you want, and take off the risk you don’t. So how do they work, and why are people using them?
Fundamental functionality
We’ve all seen the TradFi definition:
An option is the right, but not the obligation to buy (sell) the underlying at a pre-determined time and price.
Translation: options are bits of paper, which let the buyer of a 1) call (put) choose whether or not they want to 2) buy (sell) the underlying asset at the 3) strike price once the contract hits its 4) expiry date.
For example, if I buy a SOL 21MAY21 $50 call I pay a premium (the price of the option as determined by the market) in order to have the right to buy SOL (the underlying) at $50 (the strike) this Friday (the expiry). If SOL goes to $60 by then, I am now $10 “in the money” and can either sell my option for a profit before expiry, or wait till expiry to exercise the option and receive the difference between the strike and the price of Solana ($60-$50 = $10 profit).
An important concept everywhere in options are payoff diagrams. These represent what the contract (or combination of contracts) would be worth, on expiry for a given spot price. Below are the payoff diagrams for a single call or put on one SOL.
And that’s it! There’s not much else to it. The only thing missing here, is that these contracts are then always worth more than 0 — if the payoff is less than that the buyer would opt out of exercising the option when the time comes. This means that there is a 5) premium that a buyer always pays a seller for an options contract.
The buyer is paying for the luxury of being able to decide whether they want to exercise it or not, and the seller is subject to market conditions until the contract expires. This asymmetric payoff differentiates options from other derivatives such as futures (which have a continual linear payoff) and is inherently useful for allowing traders to cap their losses.
Volatility, time and options
So why do people always talk about options alongside the concept of volatility, and why does time matter?
This is because of the straddle — a structure that you commonly get from adding a call and a put of the same strike and expiry. As shown below, the combination of the two options creates a unique payoff — which is inherently a bet on volatility. That is to say you believe the price will change a lot, however you don’t know in which direction that will be.
Examining the payoff diagram, the buyer of the straddle always wins when the asset moves away from the strike, which is another way of saying that the asset is volatile. Buyers are compensated better the more the asset moves from where it began, and so straddles will always be worth more when the underlying asset is expected to move further away from the strike.
Naturally, increasing the amount of time that the asset gets to move will also increase the chance that the asset finishes even further away, so options with longer time to expiry are naturally worth more.
All in all, basic option theory therefore states that options contracts should naturally become more expensive as time increases, and also as volatility increases — that’s why investors can generate such rich yields from selling these contracts on volatile assets like digital currencies!
What’s next?
We hope you enjoyed this first post of ours, and are stoked to be building a platform that lets you take charge as traders and investors — whether that’s earning yields selling options, or speculating on price and volatility by buying them. In our next article, we’ll explore the various ways you can profit from both buying and selling different combinations of options, so stay tuned.
Shoot down any questions, and we’ll try to answer as many of them as possible! Stay in touch with our progress and join the next wave of DeFi innovation by checking out our website, joining the Zeta Discord and following @ZetaMarkets on Twitter.
Further reading
- MOVE Contracts: FTX provides a great way for traders to speculate on the price of the straddle using these specialised derivatives.
Editor’s Note: Here at Zeta, we care about educating the community and growing the sophistication of DeFi users. We want to share our knowledge on systems, derivatives, DeFi and more with the public, and are very excited to kick off our Zeta 101 series — educating readers on exciting possibilities that are coming soon on Zeta Markets.
