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Cryptos are volatile assets. Sometimes they go up, but some times they go down. When they go up it is easy to make money by buying cryptos and watching how their values increase. But there is a simple way to multiply income in this case by means of leverages with call options.
A call option on a cryptocurrency, for example bitcoin, is a contract which gives to a buyer a right to buy a specified amount of this cryptocurrency at a specified date, called an expiration date, at a specified price, called an exercise (or strike) price. A price of this contract is called a premium of the call option.
At the expiration date, an owner of a call option receives a profit equal to a difference between the price of the cryptocurrency on the expiration date and the exercise price, if the exercise price is lower than the cryptocurrency price at expiration date.
An owner of a call option can also sell the option on crypto exchanges. If the selling price will be higher than the buying price then the owner will have a profit equal to a difference in the prices minus transaction costs.
A simple way to look on a call option is as a lever, which multiplies a force needed to move heavy objects.
F1~F2*d2/d1=F2*k, where k is a multiplier.
In the same way as a lever multiplies our force, call options multiply return on investments, when prices move up. See the example below.
When there are many negative news, statements, decisions on cryptos from government officials we should expect a temporary decline in cryptos (see [1-2]). After the decline we can buy call options and wait when traders/investors who use the “buy the dip” strategy start to buy the cryptos and move the price up. When prices of cryptos move up, prices of call options also move up, therefore we can sell them at a profit.
To find undervalued call options we need to estimate values of these options using a probabilistic forecast.
Let us consider an example.
Multiple announcements by Government officials about inflation and future rate hikes resulted in temporarily decline in cryptos on February 23, 2022.
On February 23, 2022, bitcoin price was below $38,000. At that time Ms. Z believed that the price will go down to $35,000 with probability 0.2 or will go up to $50,000 with probability 0.8 till March 3.
By entering the data into input fields of the option price calculator (see https://www.ispreport.xyz/ocalc/ocalc.html) and clicking on the “Calculate” button
Ms. Z found that a premium on a call option with a strike price of $45,000 should be about $1,357.
Market participants on Binance.com priced this option at $659.95 (see below on the left side), therefore this option was undervalued by the market participants, according to Ms. Z believes.
On February 23, 2022, Ms. Z bought 1 call option on the bitcoin index with the exercise price $45,000 and the exercise date: March 25, 2022 on Binance.com. Ms. Z paid $659.95 for the option.
On March 1, 2022, market participants were buying such options for $3,035.54. See below on the left side.
Ms. Z sold the option for $3,035.54. After subtracting the initial cost ($659.95) and transaction fees (0.1%), Ms. Z had profit of $2,373.21. This is 359.6% return on investments in less than a week.
Let us compare this return on investments with a return on investments in the case if we bought bitcoin index on February 23 and sold on March 1, 2022. In this case the return on investments is only 18.5%.
Therefore, by using the call option we leveraged our return on investments in about 20 times!!!
The multiplier is equal to 359.6/18.5=19.4.
Now, let us consider a situation when the price goes to $35,000. In this case the value of the index has a loss of $3,000, but loss on the call option is only $359.6. This shows that buying options is less risky strategy than buying cryptos. In the first case a risk of loss is limited to an option premium, but in the second case the risk is unlimited. This is the first advantage of buying options (limited risk of loss).
The second advantage of options trading is a leverage. There is a simple relation between a multiplier and an average profit per trade (PPT) called the “Profitability Equation”
where Prob(Correct)% is a probability that your forecast is correct.
Let us consider an example. Suppose your Prob(Correct) is equal to 15%, Multiplier=14. Then your PPT is equal to 15*15-100=125%.
If your Prob(Correct) drop to 5%, your PPT will be 5*15-100=-25% (loss of 25%).
When you trade cryptos or options on cryptos you use your skills (you are an investor/trader), but when you hold your cryptos and hope that the prices will go up you rely on the “Lady Luck” (you are a gambler).
Let us consider two scenarios. The first scenario is that bitcoin price will go to $100,000 and stabilize.
The second scenario is that bitcoin price will go to $1 and stabilize.
Your have no control over the future events and bitcoin price. You completely rely on lack if you hold your cryptos and hope for the first scenario. When you trading/investing it does not mater which scenario will be, you make profit in any scenario if you use strategies which minimize your risks and maximize your profits (see [5]).
Historically, after each dip in crypto prices we have seen move up in the prices. This observation shows us a high potential of this method for crypto investors/traders.
Conclusion: To multiply return on investments when cryptos go up traders/investors can buy undervalued call options. It is less risky than buy and hold crypto, because there is a limit on possible losses.
P.S. 1. The example is not real, it is a hypothetical example for educational purposes, only.
2. The option price calculator is not free, you need to buy a license to use it.
3. This strategy works only when values of cryptos go up as was expected. It does not work in bear or frozen markets. It may not work in volatile markets, if your guesses about movements of cryptos are incorrect.
4. Using options on cryptos is a very risky business. Those who can not tolerate risks, should use strategies with zero or low market risk, for example friendly arbitrage (see [3]), which guaranty positive gains regardless of an outcome in the future.
5. In the case when values of crypto go down it is possible also leverage return on investments by buying undervalued put options. See [4].
6. By combining different methods and using optimal strategies (see [5]) it is possible to minimize risks to the desirable levels.
In the next post we consider a simple procedure to practice friendly arbitrage.
References
[1] Influence of Good and Bad News on Cryptocurrency Prices
https://medium.com/cindx/influence-of-bad-and-good-news-on-cryptocurrency-prices-f42ff4b89fa5
[2] Bitcoin's Largest Price Changes Coincide With Major News Events About the Cryptocurrency
https://www.aier.org/article/bitcoins-largest-price-changes-coincide-with-major-news-events-about-the-cryptocurrency/
[3] Friendly arbitrage
[4] A simple way to make money when values of cryptos go down
[5] Simple optimal betting/investment strategies
https://www.publish0x.com/simple-solutions-to-complex-problems/simple-optimal-bettinginvestment-strategies-xrnvojr
