A Few Not So Crazy Ideas About the Future of Cryptocurrency Options
Options are coming to the world of Bitcoin and digital currencies. In the last few days, I’ve published a couple of analyses about recent market developments that signal a more mainstream trajectory towards Bitcoin Options and Futures. Most notably, startup LedgerX recently received regulatory approval to start creating Bitcoin option contracts and the CME Group announced its intentions to start trading Bitcoin futures. With the prospect of Bitcoin options coming into the market, it is only logical to assume that new forms of derivatives and more sophisticated types of options will soon follow. How would those look like? That’s the topic of today’s post.
Most people who follow financial markets are familiar with the classic type of option based on a call and put contracts. In that model, a call option is a contract that allows an investor to buy, at some point in the future, a specific share at a preset price. Similarly, a put option is a contract that allows an investor to sell a share in the future for a specified price. Using market terminology, the strike or exercise price is the price the investor sells or buys the option for. The expiration is the date on which the investor needs to exercise the option and the premium is the amount the investor pays upfront for the right to buy a share. While that traditional model for options is certainly the best established one is far from being the only one. Enter the world of quants and financial derivatives.
Quantitive traders or quants have taken the financial market by storm building products that leverage statistics to price financial assets. The world of options and futures is quantland and, over the years, the market has seen the creation of many exoteric option contracts produced by the creative of quants. Many of those products are likely to find an equivalent in the world of digital currencies. Let’s look at two well-known examples:
— Up-and-Out Option: Suppose you believe that the price of a cryptocoin is going to increase but only in a limited way. The Up-and-Out call option works like standard call option in the sense that it pays off if the price of the underlying asset raises, but in the event of a drastic price increase, then a preset trigger activates and the option becomes worthless. Typically, the trigger level is set a level above the predicted price of the cryptocoin.
— Multi-Asset Option: Intuitively, we associate options with a single type of assets such as Bitcoin. However, there are other types of options that pay off based on the behavior of multiple assets. For instance, in the digital currency world, we can envision a Multi-Asset option based on the best performing of the top 10 digital currencies.
A Match Not Made in Financial Heaven
The world of Bitcoin and digital currencies is constantly subjected to speculative behavior by investors which causes regular volatility in the price of crypto assets. Combining digital currencies with exoteric financial derivatives can have unpredictable effects in the short term. However, some of the well known strategies for pricing options might help to add some stability to the price of digital currencies. More about that in a future post.