Hedging on Mettalex: Comparison to Options
Jun 10, 2021
Introduction to Hedging
In the first blog post of the hedging-dedicated series, we outlined what hedging is and why you should practice it in order to reduce your portfolio’s exposure to risk. In the current post, we’ll focus on one of the main financial instruments used for hedging – options.
What Are Options Contracts?
Options are a financial derivative which means that their value is derived from the performance of another asset. That underlying asset or set of assets may be almost any kind of equity, currency, commodity, market index, etc. Investors and speculators use options contracts to generate additional income or hedge against unexpected price movements and volatility. Trading options may hide a lot of risks and to do it successfully, one needs to be able to properly predict the future performance of stocks, bonds, indexes, currency, or commodities.
The options contract gives the buyer the right, but not the obligation, to acquire or sell the underlying asset at the predetermined price and at or before the predetermined date.
An option is basically a contract where a buyer and a seller agree on a fixed price for an asset and a fixed period of time. Let’s break this down:/
- The participants in an options contract are: a buyer (also referred to as the holder or the owner) and a seller (also known as the writer). The buyer is taking the long position in that contract, whereas the seller is shorting.
- When entering the options contract, the buyer pays to the seller a premium i.e. the current market price of the contract.
- The fixed price for the underlying asset i.e. the price at which the asset will be available for purchase / sale at the moment or before the contract expires is called the strike / exercise price. The strike price is determined by the exchange where the options contract is traded and is fixed below or above the spot price of the asset according to market sentiment.
- Every option contract has an expiration date or maturity. Depending on the style of the options*, the buyer has the right to exercise the contract before or at that date.
* US – style options can be exercised any time prior to or at the same day of expiration, whereas the European style options can only be exercised at expiration.
Types of Options
- Call option: when buying a call option, the holder is free to choose whether to buy / take delivery of the underlying asset. If they decide to exercise it, the seller is obliged to sell / deliver the asset.
- Put option: when purchasing a put option, the owner has the right to sell / deliver the agreed upon asset. Here again the writer is required to purchase / take delivery of the asset if the contract is exercised. A clearing organization usually acts as a counterparty and guarantees the options would settle even if the writer fails to meet their responsibilities.
The prices of a put and a call options are inextricably linked to each other and to the price of the underlying asset.
Let’s take a look at some of the popular trading strategies when dealing with options contracts and the potential gains and losses associated with them.
In order to enter an options contract, you are required to make a minimum investment that equals the amount of the premium. The premium may fluctuate over time and is closely interlinked with the price of the underlying asset. Besides that, the premium may also be influenced by the asset’s volatility and the option’s maturity period.
After buying an option, the holder has a few choices: 1) they can exercise the option and purchase / sell the asset before or at expiration, 2) they can resell the contract before expiration, or 3) they can let the option expire without exercising it. In that case, the options contract becomes worthless and the premium paid in the beginning represents the buyer’s maximum loss and the seller’s maximum gain.
When investing in a call option, the buyer expects that the price of the underlying asset will rise prior to the contract’s expiration. If the market is bullish and the asset’s spot price does rise above the strike price, the option referred to as “in the money”, may become increasingly profitable and the buyer may offset the premium they paid. The higher the asset’s price in relation to the strike price, the higher the option premium. And vice versa – the smaller the probability is for the asset’s market value to reach the strike price, the less expensive the premium is. If the asset’s price falls below the strike price, the option is set to be “out of the money” – the holder then is exposed to losing the premium they had invested.
On the other hand, in a bear market a buyer invests in a put option with the expectation for the price of the underlying asset to fall below the strike price. If it does indeed decrease, the option’s value will appreciate and the option will be “in the money”. The lower the asset price in relation to the strike price, the higher the option’s premium. Inversely, if the strike price falls below the asset’s price, the less expensive the premium.
Overall, the biggest loss an option’s buyer may suffer is losing the premium they paid, whereas the seller is exposed to unlimited risk of loss since they need to be sufficiently capitalized to deliver any required asset.
Here’s an example to illustrate all this:
The asset’s spot price is $10. There is an option based on that asset that offers a strike price of $10.25. Its premium is $0.50.
A buyer pays the $0.50 premium and acquires the option. If the asset value increases by just 10% and reaches $11, the option’s value will rise to $0.75. Our buyer can then resell the option and both offset the initial investment and generate a 50% profit.
Otherwise, if the asset’s price drops to $9, the option is “out of the money” – the holder can no longer resell the contract and will probably let it expire without exercising it, thus losing the premium.
Types of Options Contracts Available in the Crypto Space
The crypto space is accommodating an ever growing number of sophisticated financial instruments. Crypto-based options are getting more and more popular since they are a convenient tool for hedging against unexpected price movements. As of February 2021, the amount of money locked in active options reached an all-time-high of $13b.
Crypto options are exactly the same as the traditional options contracts described above, except that crypto markets are open 24/7/365. The main difference is that the crypto options are usually based either on BTC or on ETH, although options derived from other crypto assets such as EOS also exist.
The largest exchanges that currently offer crypto options trading are FTX, Bit, Deribit and OKEx, but many others exist. Options are not as popular as the crypto futures among traders but they offer the advantage of being a low-cost and low-risk solution. Options are most often used either to limit potential losses or to generate profits in periods of high volatility.
Crypto options contracts are usually based on 1 BTC or 1 ETH and may have different maturity – from daily to bi-quarterly. Both Deribit and OKEx settle the contracts in cash i.e. no assets are exchanged, just profits / losses are credited / debited to participants. In addition, both exchanges employ European-style options – they can be exercised at maturity only and this is done automatically.
Let’s see how this works with an example:
Hypothetically, BTC’s price is $35,000. A trader buys a two-month call options contract offering a strike price of $40,000 at a premium of 0.05 BTC. Two months later at expiry BTC soared to $42,000. The buyer exercises the contract and records a profit of $2,000 minus the premium of 0.05 BTC they have paid. The seller will be obliged to sell 1 BTC below the market price and thus will record a loss.
If the price of BTC falls below the strike price, the contract becomes worthless and will not be exercised. Then, the premium would be recorded as a loss for the buyer and again for the seller.
“Naked” vs. “Covered” Option Positions
As mentioned before, options are usually used as a hedging instrument which means that traders invest in option contracts in order to protect other holdings against unpredictable risks. In practice that could be illustrated by the so called “covered” options – buying an option while simultaneously holding the opposite position of the underlying asset. For instance:
A trader who holds 1 BTC currently worth $35,000, is anxious that the price may fall. He issues a two-month call option with a strike price of $34,000. That way the trader is simultaneously holding a long position of BTC and profiting from the premium if the price declines. If the price falls below the strike price the options contract would be “out of the money”, the buyer would not exercise it, and the seller would keep the 1 BTC and record a profit equal to the amount of the premium. If, however, the price goes up to $36,000, the options will become profitable and the seller will record a loss equal to (($36,000 – $35,000) – the premium). Therefore, “covered” options offer limited gains but also limited risk of losses.
On the other hand, if that was a “naked” options contract i.e. the seller did not hold any BTC at the time the option was created, he would be obliged to buy BTC at market prices and deliver it whenever the contract is exercised. Indeed, “naked” options do not require any capital to be invested upfront but they may hide much greater risks. Still, many speculators bet on their luck and enter such contracts with the expectation of harvesting premiums.
Exploiting the Volatility
Options are generally the preferred instrument in times of high volatility and that is even more valid in the crypto space. A recent trend among crypto traders has been the creation of ultra-bullish options contracts. As of May 31st, 2021 there were more than 24,000 open BTC call options with a strike price of $100,000 or higher. The less probable it is for BTC to reach that price, the less expensive the contract is, but sellers may issue a big number of options and gain from the premium. At the same time, buyers hope that every upward price movement of BTC would appreciate the contract and they could resell before maturity, with a profit. If BTC does not reach that threshold at maturity, the contract would simply expire worthless.
Mettalex’s Position Tokens Compared to Options
The Mettalex decentralized derivatives exchange presents a new paradigm in trading. First and foremost, Mettalex combines commodities and cryptocurrency derivatives and thus unlocks opportunities that are not available anywhere else in the decentralized finance (DeFi) space. Crypto traders will find new and unique markets, whereas traditional commodity investors/physical holders will discover a capital and cost efficient hedging/trading tool. The DEX is also developed to be easy to use, demolishing the high entry barriers of other derivatives trading platforms.
Mettalex allows for traders to take long (L) and short (S) positions against a range of reference assets including crypto and traditional commodities.
Compared to both traditional and crypto options, trading on Mettalex offers a number of advantages and similarities:
- No obligations to purchase/sell the underlying asset. Similarly to options contracts, on Mettalex there is no obligation to purchase or sell the underlying asset. All settlement is done in a stablecoin – BUSD and USDT currently. There is also no counterparty that is obliged to settle the contract i.e. to deliver/receive or buy/sell the asset. All participants on Mettalex trade only with the autonomous market maker and not with each other, so there is always a counterparty to any trade.
- Stablecoin settlement. Since there is no exchange of assets on Mettalex, there are no fees associated with physical storage or delivery of the asset, unlike commodity options with physical delivery.
- No premium. When trading options contracts, the buyer pays a premium while the seller needs no capital upfront to enter the contract. In contrast, on Mettalex all participants are equal. Every trader pays a minimal trading fee (called a “spread” in the DEX) for the long or short tokens. In addition, with options, changes in the premium’s price are strongly affected by how close the contract is to maturity and the current asset price whereas no such correlation exists with Mettalex’s tokens.
- No expiration date. Unlike options, position tokens on Mettalex do not have a predetermined expiration date. Positions will remain open until the price band is breached by the oracle-reported spot price. If the real-world price of the asset breaches the band, the market is settled automatically and all of the collateral becomes claimable by the holders whose position tokens were “in-the-money” (ITM). Long token holders will be ITM if the band’s cap is breached, while short token holders will be ITM if the bottom is breached. The new spot price and the historical market volatility will determine the new market band. Once a new market is launched new position tokens can be traded again.
- Fully quantified maximum loss. Just like in the case of options buyers, a trader on Mettalex knows the maximum loss they can incur before entering the position. That is composed of the cost of buying the position tokens and the exchange fee (spread). Unlike options contracts, however, Mettalex users also know the maximum profit that a certain position can generate. Both the maximum loss and maximum profit are determined by the price band and the oracle-reported price that the user opens a position at.
- 24/7/365 settlement. Like most crypto-focused options platforms, on position tokens on Mettalex can be bought or sold at any time before price band breach.
- Asymmetric opportunities. Leverage on the Mattalex DEX is dependent on the ratio between the spot price and the price of long/short position tokens as these will be only a fraction of the market spot price. As the spot price for specific crypto or traditional commodity moves away from the center of the band, it becomes cheaper to buy exposure for the position opposite the movement.