It is already a big month for Bakkt, with daily volumes and open interest consistently breaking records, and the CEO of Bakkt, Kelly Loeffler, being appointed to the United States Senate. That is just the beginning, however, as Bakkt will launch the first regulated and compliant Bitcoin options market — aka options contracts for Bitcoin futures — on Monday, Dec. 9. Bakkt’s biggest competitor, the Chicago Mercantile Exchange (CME), is also launching Bitcoin options on Jan. 13.
Bitcoin Options and Bitcoin Futures: How They Work?
Both options and futures contracts are agreements to buy/sell Bitcoin (BTC) at a specific price by a specific date. The main difference is that a futures contract requires a buyer/seller to buy/sell Bitcoin (BTC) on a specific future date. Options contracts give a buyer/seller the right but not the obligation to buy/sell at a specific price.
It is important to note that there are two different types of options: American and European. American options allow a buyer/seller to execute the contract at any time once the strike price is reached whereas European options do not allow execution of the trade before the expiration date. So American options are more flexible and allow for more profit potential. Unfortunately, Bakkt and CME will be using European options.
Now, to explore the mechanics of how Bitcoin options contracts work. There are two types of options, call options and put options, with a call option being an offer to buy Bitcoin (BTC) at a certain price and a put option being an offer to sell Bitcoin (BTC) at a certain price. For either type of Bitcoin options contract a strike price is chosen, which is the price at which the Bitcoin options contract can be exercised.
Also, it is important to understand that one of the traders participating in an options contract is the options buyer, while an options writer is on the other side of the trade. The options buyer must pay the premium that the options writer sets for the contract. This premium is determined by market forces.
Examples of Bitcoin Call and Put Options Scenarios
An example of a successful call option is if the price of Bitcoin (BTC) is $7,000, and the options buyer puts their strike price at $7,500 and pays a $200 premium for the contract. If Bitcoin (BTC) rises to $8,000, the trader can then execute the call option and buy Bitcoin (BTC) for $7,500 — their strike price — even though it is worth $8,000. This yields a profit of $300 for the options buyer. The options writer simultaneously loses $300.
An example of a failed call option is if the price of Bitcoin (BTC) is $7,000, and the options buyer puts their strike price at $8,100 and pays a $200 premium for the contract. Then Bitcoin (BTC) only rises to $8,000. Since the strike price was not reached the contract will expire, causing the options buyer to lose the $200 premium they paid for the option. The options writer simultaneously profits $200.
An example of a successful put option is if the price of Bitcoin (BTC) is $7,000, and the options buyer puts their strike price at $6,800 and pays a $200 premium for the contract. If the price of Bitcoin (BTC) drops to $6,000, the options buyer can sell their Bitcoin (BTC) at $6,800 even though it is only worth $6,000, yielding a profit of $600. The options writer simultaneously loses $600.
An example of a failed put option is if the price of Bitcoin (BTC) is $7,000, and the options buyer puts their strike price at $6,500 and pays a $200 premium for the contract. Then Bitcoin (BTC) only drops to $6,900. The options buyer will lose the $200 premium, and the options writer simultaneously profits $200.
Technically, the option buyer’s risk is limited to losing the premium while the option writer is taking on unlimited risk. For example, let’s say the price of Bitcoin (BTC) is $7,000. The options buyer does a call option and puts their strike price at $7,500 and pays a $200 premium for the contract. Then Bitcoin (BTC) rallies to $20,000. In this case the options buyer would profit $12,300, while the options writer loses $12,300. If the options writer won in this case, the profit would have only been $200. So you can see how options writers might end up taking big losses even though they were only trying to get a relatively small reward.
That being said, statistics show that options writers win 75% of the time, meaning 75% of options contracts do not reach their strike price before the expiration date.
Apparently, options markets can be used to conduct a plethora of trading techniques involving a combination of Bitcoin options contracts, actual Bitcoin (BTC), and other derivatives like Bitcoin futures contracts. One common tactic is to hedge the market risk of holding Bitcoins (BTC) with options contracts. That means the launch of Bitcoin options markets on Bakkt and CME will open up a whole new realm of trading possibilities in the crypto space.
CME Bitcoin Options Contracts Can Be Physically Delivered
CME Bitcoin futures are cash-settled, meaning no actual Bitcoins (BTC) are involved. However, the Bitcoin options market opening on CME on Jan. 13 will offer physical delivery of Bitcoins (BTC). That’s in addition to offering delivery of the futures contracts which underlie the options contracts. Just like CME Bitcoin futures, the options contracts will expire on the last Friday of every month.
The Bakkt Options market will offer settlement via cash, physical Bitcoins (BTC), and delivery of the underlying futures contracts.
Interestingly, CME will initially be offering Bitcoin options all the way out to December 2021. Therefore, people who expect Bitcoin (BTC) to rally long term can make enormous profits if they are right, with the only caveat being they will have to wait until the contract expires.
The first regulated Bitcoin options markets are coming to the crypto space via Bakkt and CME, approximately two years after the first regulated Bitcoin futures markets arrived. In the same way that Bitcoin futures markets expanded the possibilities for crypto traders, Bitcoin options markets will open up a variety of new trading strategies and opportunities as well.
It is likely that volume will start off slow on these new Bitcoin options markets, but eventually, they may obtain high volumes, at which point they could have an impact on the spot and futures markets. That being said, it is too early to know how exactly Bitcoin options markets will impact the spot price of Bitcoin (BTC).