Hello Steemitans!
Today, I am going to share some of my thoughts on methods for controlling risk in the world of cryptocurrencies. By the way, none of this is investment advice. As you probably know very well, you should always do your own research. With that introduction, let's begin exploring options and some of their properties and use cases.
In traditional investments, derivative contracts, whose value is "derived" from that of the underlying asset, provide a major method for risk control. For instance, if an investor owns stocks whose value may fall, temporarily, in the near future, instead selling the stocks, to "avoid" the risk, or holding them based on the long-term view of rising prices, the stock owner can limit the downside risk without limiting the upside potential, by buying options. The option contract useful in this case are put options, which give their owner the right, but not the obligation, to sell the stock at a specific price, called strike price, at the expiry date of the option contracts.
For instance if the asset is currently traded at 100, and may fall significantly below that, the investor in that asset can buy put options which give him/her the right, but not the obligation to sell the asset at 90. If the price is 100 at the moment, the right to sell it at 90 right now is not useful and the option is called "out of the money" and are normally traded cheaply, perhaps one tenth of the current market price. However, if the asset falls to 60 at a future date, the right to sell it at 90 is obviously worth 30. The investor who owns 1000 units of the asset and has purchased 1000 put options, has in reality insured his investment against any fall below the price of 90. But if he/she holds 1000 units of the asset and has purchased 2000 put options, he/she will profit 300% on the put options during the dip. Why is this interesting, one might ask, because if you are bearish on an asset, you can surely short it on leverage! The answer is that short-selling comes with high risk of bankruptcy. Essentially when you are selling short, you are assuming an obligation (debt) to deliver an asset, but when you buy put options, you have a right but not an obligation. Here is the key difference. You can never lose more than the price you have paid for options; your risk is capped. If you are selling short, your risk is not capped. Some influential figures in risk management, such as Nassim Nicholay Taleb, the theoretician of black swans, believe that there is absolutely no way to short bitcoin without a good chance of going bankrupt.
So far we discussed the risk of falling prices, but how can options be used in a bullish scenario? The call options give the owner the right to buy an asset on the future date (expiry date) at an agreed price (called strike price). Lets us consider a call option for an asset currently valued at 100 to be bought at 120 three months from now. In this scenario, the right to buy at 120 does not have any value right now, it is "out of money" and it is possible to buy it cheaply, perhaps at 1/10 of the asset price. However, if the asset price triples and reaches 300, the option, the right to buy at 120, would be worth 180, representing an 18x gain. This appears like unfortunate news for the seller of options, but in truth if the seller of options is operating properly, he/she is an insurance company and would profit handsomely form these trading activities.
What we said so far was based on traditional investments. In cryptocurrencies, options markets are not very well-developed. It's a shame because options provide sophisticated risk management for investors which are simply not possible using simpler trading models. As cryptocurrency markets become more sophisticated we may see more possibilities for options contracts, which, I believe, would be a very interesting development.