Options are specialized contracts that grant the holder the right (but not the obligation) to buy a financial asset in the future on a specific date and at a predetermined price.
Example. How options work
Suppose you have bought an option:
- its duration is 1 month,
- it gives you a right to buy 1 Bitcoin
- at the price of $30,000.
If one month later you see that the price of Bitcoin is $35,000, you can use your option to buy the coin at a price lower than the market value.
Our profit in this case will be $5,000 minus the cost of purchasing the option.
But there is another scenario to consider. Let’s say the price of Bitcoin drops to $25,000. In that case, you can simply say, “I’ll pass” and not exercise your right to purchase.
In this scenario, your loss is limited to the cost of buying the option.
It is very beneficial because the cost of the option (known as the “premium”) is a fixed amount. This is how options help you limit your losses. For instance, you have bought an option for $200 and Bitcoin has dropped by $5,000. Your loss is only $200, not the full $5,000 that you could have lost in the futures or spot markets.
Options are more complex in comparison to stocks, cryptocurrencies, or futures, as they have specific nature which is unique to these markets. However, this complexity allows for risk reduction, the creation of new trading strategies, and the optimization of existing ones.