I often get asked this question, a lot: ‘What do you do, when the price of Bitcoin trades in a price channel?’ E.g. If the price fluctuates between $7000 to $10,000 over the entire year.
Despite being a long-term holder of the digital asset, I can see the appeal of making some short-term trades. The biggest challenge for mid to long-term investors like us, is the opportunity cost in buying and holding.
This is where Financial Derivatives come in: Important Financial instruments which offer various types of risk protection and allow for innovative investment strategies.
Today I’d focus on Exchange-Traded Options, which first started back in 1970s. The general public views options as High-Risk investments meant only for Expert traders, but in reality, options can be useful to the individual investor.
Some advantages of Options and the value they can add to your portfolio:–
- Cost Efficiencies and Asset Substitution
- Potential to Deliver Higher-Percentage Returns
- Risk Management
- Income Generation
- Allow Execution of Innovative and Alternative Strategies
Cost Efficiency and Asset Substitution
In simple terms, you can use less starting capital to get a similar result. If you already invest in assets like gold or Bitcoin, you can use Options to achieve a higher % returns, and also use certain investment techniques that utilise time to your advantage.
Before I go further, let’s start with some essential basics: 2 types of options, the ‘Call Option’ & the ‘Put Option’.
The ‘Call Option’
This allows the holder to buy the asset at a fixed price, should he/she choose to do so.
Think of it like your Option to purchase agreement when buying a property. Once you have gotten that contract, you can choose to purchase the property at the price (Say $1million) that was fixed in the contract.
In the event you don’t move forward, you will forego your Option fee – usually 1%.
In Bitcoin, a ‘Call Option’ looks something like this: Today the price is $7,500 per BTC. I sign a “contract” to purchase the BTC one month later for the same price of $7,500, and my Option Fee is $300.
If the price of BTC is $8,000 next month, I will exercise my option, and purchase the BTC for $7,500 (which is $500 below market rate).
In this event, I would have netted profit of $200 ($8,000 – $7,500 – Cost of Options [$300]).
OR: If the price of Bitcoin is $7,000, I would not exercise my options, and I lose $300.
So as you can see: Options allow you to leverage on your positions, and for the astute investor – this would mean Excellent Cost Efficiencies.
Anyone can build an Option position similar to a Stock position, but at huge cost savings. The maximum capital exposed (in this example), is merely $300, but allows for gains.
This table illustrates how a Call Option looks like. Assume this Option expires in ONE month.
| Price of BTC | $10,000 |
| Strike price | $10,000 |
| Option fee | $300 |
| Max loss | $300 |
| Max gain | UNLIMITED |
*Here’s what happens one month later.
*The Math behind this: Current Price of BTC – Strike Price – Option Fee = Profit
| Price of BTC | Actual Gain/Loss |
| $10,000 | – $300 |
| $2,000 | – $300 |
| $11,000 | + $700 |
| $15,000 | + $4,700 |
As you can see: the % Return on Capital ($300) is Pretty Attractive! Most of the time, Options Trading gives higher % Return on Capital, as compared to actually buying and holding the underlying asset!
Risk Management
Risk management is something I like when it comes to using options on my BTC as well. It’s somewhat the same way a trader (finance) uses “Stop-Loss” to manage risk.
Here’s an Example:
I purchased BTC at $10,000 and I set a stop loss of $9,000. So, when BTC price falls and hit $9,000, my trade will get executed and I end up with $9000 and no more BTC.
This works well for traders and I highly urge every Day-Trader to have a ‘Stop Loss’ in play.
However, this might not work for someone who is a ready to hold BTC mid – long term: Since my goal is to accumulate at least 5 BTC for myself (Find out why in my other articles), I do not want to trade BTC daily.
Also, the volatility of BTC is very high and moves very quickly.
I had an experience where I purchased BTC for $7,300 and placed a stop loss of 10%. My logic was that if BTC fell by 10% to $6570, it would continue to fall, and I’d be able to buy back more BTC when it falls lower to $5,000.
And here’s how it actually went:
The ‘Put Option’
Purchasing a ‘Put Option’ might be a more dependable form of hedging, which provides insurance 24/7. You can also choose to hold and wait to observe price movements before the option actually gets executed.
Income Generation: ‘Golden Grail’ for BTC Holders Like Me
In mainstream finance, something very similar happens: Options enable investors to generate income from their stocks or ETF fund portfolio.
The way to approach this, is via a ‘Covered Call’ or perhaps a ‘Buy-Write’.
Let’s use the ‘Covered Call’ as an example here: where the investor already owns the stock and forecasts its price will remain steady – or rise slightly.
Basically, he / she intends to hold this stock for longer term, and what can be done, is to write a call against the stock being held. The Strike Price of the call sold limits the upside but generates an income via a premium.
Example by Gary Delany of the Options Industry Council (OIC):
Imagine XYZ is a type of Cryptocurrency: I’ve gotten 100 XYZ for $52 per share adding up to total investment of $5200.
I then sold a covered call for $1.75 with Strike Price of $55.
What I’m hoping if that the share price will go up, but in the event that it does, I will still be able to pocket $175 ($1.75 X 100 XYZ).
The Best Outcome would be: If the price went to exactly $55 per XYZ when the option expires – as per the image, I would reap total profit of $475.
By foregoing potential upside, I’m gaining extra income on the assets I’m holding on to.
Execution of Innovative and Alternative Strategies
Lastly, we can use options to perform more advanced strategies, which will give pre-determined and specific outcomes at varying price levels.
Combining Options and Bitcoin, there are limitless strategies which we can construct and execute. Below is a screenshot of my USD earnings (~$1500) in Oct 2019.
Conclusion
We can see how investors can use Options as versatile tools to mitigate risk, generate income, harness leverage and participate in Cryptocurrency markets with calculated risk.
Most importantly, I am able to used options in conjunction with my Bitcoin to create targeted outcomes.
As back to original topic and frequently asked question on, “What do you do, when the price of Bitcoin trades in a price channel?”
My Answer: Use Financial Derivatives! Like Options. To enhance returns, even as the market recovers.
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