June 1, 2021
Dopex Essentials: Calls and PutsDopex-Essentials
Trigger Warning: Simple Mathematics
Hey, we hope you’re enjoying and learning from the Dopex Essentials series so far. Episode 1 was a simple overview of options and episode two dove into some fairly more complex areas of options trading. We did that because we needed to get everyone acquainted with the basics of Dopex’s pricing mechanism.
Going forth, we are going to go back a couple of steps and discuss some of the key subject areas and basics of options trading.
Today’s article will focus on the two types of options. Call options and Put options. As always we like to keep it fun and interactive and without further ado let’s jump right into it.
Once upon a time in a faraway land somewhere in the cryptoverse lived a gorgeous woman named Hannah. Hannah is selling her house for $300,000 in a neighborhood that has a nearby piece of land that is for sale as well.
There are two people interested in this nearby piece of land. Chad and Mario. Mario plans to develop the land into a beautiful park and botanical garden, meanwhile Chad plans to build a low-cost strip mall.
Another guy, Xen, hears about this new house on the market and is interested in buying the house — with cash. Unfortunately, Xen isn’t very liquid at the moment and won’t have the cash available for three months. Because of this, Xen is worried that Hannah will sell to someone else before he has the money.
Then, Xen has a true gigabrain moment, he offers Hannah $10,000 upfront (option premium). If she’ll take the house off the market for 3 months and give him the option (call option) to buy the house for $300,000 (strike price), after 3 months (expiry date).
After the 3 months, if Xen no longer wants to buy the house, then Hannah will keep the $10,000 premium and Xen walks away from the deal. If Xen does decide to buy the house (exercise the option), Hannah still gets to keep the $10,000 premium and Xen pays her the $300,000 for the house.
Three Scenarios Could Play Out In This Story:
Let’s say that Mario buys the land nearby Hannah’s house, and develops a park and botanical garden. This, of course, will increase the value of Hannah’s house to say $400,000 in which case Xen will be very happy to exercise his option to buy the house for $300,000.
Let’s say, Chad buys the nearby land and develops a low-cost strip mall. This will decrease the value of Hannah’s house to say $200,000. In which case Xen would rather not exercise his option to buy the house at $300,000 and instead he’ll just walk away from the deal, having lost only $10,000.
Neither Mario nor Chad buy the nearby piece of land. So the value of Hannah’s house neither decreases nor increases and remains at $300,000. In this case, Xen can choose to exercise his option to buy the house for $300,000 or just simply walk away from the deal, having lost only the $10,000 dollar premium in both cases.
Essentially, Xen is controlling a $300,000 asset for three months for only $10,000. No matter what happens during that time, the most he can lose is $10,000.
Back to the story…
Hannah is delighted to take the $10,000 premium. She had no guarantee anyone else would buy the house at her asking price, nor did she feel the nearby parcel of land would sell anytime soon.
Depending on the circumstances, if Hannah felt she was likely to attract another buyer in the near term, she would have demanded more than $10,000 from Xen to take the house off the market for three whole months.
And that’s the same with call options. The more the underlying asset is perceived to appreciate, the higher the premium demanded by the market for that call option.
Call Options In Trading Terms
Definition: A call option is a contract between two parties to exchange an asset at a predetermined price (strike price) at a predetermined date (expiry date).
One party, the buyer of the call, has the right but not an obligation to buy the stock at the strike price by the future date. While the other party, the seller of the call, has the obligation to sell the stock to the buyer at the strike price if the buyer exercises the option.
If Bitcoin is trading at $50,000 and you expect it to go up to $60,000 after one month (expiry date). You might buy a $55,000 call option for, say, $200. If Bitcoin has risen to, say, $60,000 by the expiry date, that would allow you to buy bitcoin at $55,000 (strike price) even though it’s valued at $60,000, netting you a profit of $4,800 on each Bitcoin.
Whereas, the person that sold you the call would be obligated to sell you the Bitcoin at $55,000 and at a loss of $4,800 on each Bitcoin.
However, if Bitcoin does not rise above $55,000 by the expiration date, the call option expires worthless and you as the call buyer lose your $200 premium and the call seller keeps that $200.
Now let’s take a dive into put options using Hannah and Xen again.
Xen is a Wallstreetbets legend who made a fortune off GameStop and Hannah is an insurance broker.
Let’s say Xen owns an Aston Martin DBS Superleggera worth $300,000; naturally, he’s worried that his car might be damaged in an accident, keyed by his girlfriend, or maybe stolen.
Once again, Xen has a gigabrain moment and decides to purchase a zero-deductible insurance policy (this is essentially a put option) on the Aston Martin for its full value of $300,000, which would be the strike price.
Hannah’s insurance company charges Xen $90,000. This would be the option premium for a one-year policy, one year being the expiration date.
Three Scenarios Could Play Out In This Story:
Xen’s Aston Martin is not damaged or stolen during the year. In that case, Hannah keeps the $90,000 premium. Xen is fine with losing the $90,000 for the protection it provided his car for the year.
Xen’s Aston Martin is damaged in an accident (moment of silence) and requires $75, 000 for repairs. Xen chooses to exercise his insurance policy (his put option) by filing a claim, and Hannah pays him the $75,000 required for the repairs as agreed. Xen is ecstatic that he purchased protection for this possibility.
In this scenario, Xen’s Aston Martin is stolen (probably by Chad). Anyways, he exercises his insurance policy (his put option) and files a claim, but this time for the full replacement value of his car. So, as agreed, Hannah pays Xen the full $300,000 to buy a new car. Xen is very happy he purchased protection for this possibility.
Back to the story…
In any case, Hannah is also happy because she sold many insurance policies (put options) just like the one she sold Xen. Most of these drivers never file a claim (never exercise their options) providing her with a net profit overall.
That said, if Xen had a terrible driving record, then selling him the insurance policy would be more of a risk to Hannah. Therefore, she would have charged him more than $90,000 for the one-year insurance policy. On the other hand, if Xen had a great driving record, Hannah would have charged him less as the risk would be lower.
This applies to put options as well. The higher the perceived risk, the higher the premium demanded by the market.
Put Options In Trading Terms
Definition: A put option is a contract that gives the buyer the right to sell an underlying asset to the put option seller at a predetermined price known as the strike price.
The buyer of the put has the right but not an obligation to sell the asset at the strike price, at the future date (expiry date) while the seller of the put, has the obligation to buy the asset from the buyer at the strike price if the buyer exercises the option at the expiry date.
If $ETH is trading at $5,000 and you believe it’s going to go down to $4,000 by the end of a one-month period (expiry date), you might buy a $4,500 put option for, say — $200.
If $ETH is below $4,500 by the expiry date, let’s say at $4,000. That would allow you to sell $ETH at $4,500 even though it’s valued at $4,000, netting you a profit of $300 dollars on each $ETH.
On the other hand, the person that sold you the put would be obligated to buy the $ETH from you at $4,500, which would be a loss of $300 on each $ETH.
If the price of $ETH does not drop below $4,500 by expiration date, the put expires worthless, the buyer loses the $200 premium and the seller keeps the $200.
We hope that this article gives you some more understanding of the basics of put and call options.
The next Dopex Essentials Episode will go into some more details about puts and calls covering the subject with a bit more depth and we’ll also go over the advantages/disadvantages and the risks of buying/selling both puts and calls.
Dopex is a decentralized options protocol that aims to maximize liquidity, minimize losses for option writers and maximize gains for option buyers — all in a passive manner.
Dopex uses option pools to allow anyone to earn a yield passively. Offering value to both option sellers and buyers by ensuring fair and optimized option prices across all strike prices and expiries. This is thanks to our own innovative and state-of-the-art option pricing model that replicates volatility smiles.
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