Understanding a Put Option
When it comes to option trading with cryptocurrencies, a Put Option is a fundamental concept that traders should understand. In its simplest form, a Put Option is a contract that gives the owner of the option the right (but not the obligation) to sell a specified amount of an underlying instrument like a cryptocurrency at a predetermined price within a specific time frame. This is done with the expectation that the price of the underlying cryptocurrency will decrease.
Functional Elements of a Put Option
A Put Option consists of several core elements. The buyer of the option pays a premium to the seller in exchange for the right to sell the cryptocurrency. The predetermined price at which the cryptocurrency can be sold is known as the strike price. If the market price of the cryptocurrency falls below this strike price during the contract period, the put option can be exercised profitably.
Why Trade Put Options in Cryptocurrency?
Traders opt for a Put Option in a bid to capitalise on a downward price movement of a cryptocurrency. If they forecast that a certain cryptocurrency's price will fall, buying a Put Option would allow them to profit from that prediction. It can also serve as a form of insurance, protecting a person's investment in the circumstance that the asset depreciates.
Example of a Put Option in Cryptocurrency Trading
For instance, imagine you own 1 Bitcoin (BTC) that you bought for $50,000. You predict the price will fall in coming months, so you buy a Put Option with a strike price of $48,000 for a fee (premium) of $500. Now, if the price of bitcoin falls to $40,000, you have the right to sell your bitcoin at the strike price of $48,000. Therefore protecting yourself from bigger losses.
Risks and Rewards of a Put Option
Just like other forms of financial options, the Put Option comes with its set of potential risks and rewards. The maximum risk for the buyer of a Put Option is capped at the premium spent, while the reward can be substantial if the cryptocurrency prices fall significantly. For the seller of a Put Option, risk can be high (potential loss of value of the underlying cryptocurrency) but the reward is limited to the premium received.
