WTF are options?

If you don’t come from a financial background just like me, options can be quite overwhelming. Let's try to break them down in an easy to understand way. Options are derivatives, which are financial contracts that - as the name suggests - are derived from other financial assets. There exist basically two different kinds of options, call options and put options, both of which I will explain in detail later. Options are contracts which allow the holder to buy or sell an asset (in TradFi mostly stocks, in crypto mostly BTC, ETH) at a certain price (which is called strike price) in a predefined time frame (called expiration). So why would someone want to do that? There are basically two use cases for options:

1. Limit risk exposure. This is basically the objective of option buyers. To hedge the downside (FUD in crypto jargon) of an asset, the investor will buy put options. To hedge the upside (FOMO in crypto jargon) of an asset, the investor will buy call options.
2. Gain additional yield on an asset. An investor can sell options and collect premiums to gain yield on his assets (this can work for both bullish and bearish outlooks).

Call options

The option seller (also called writer, owns an asset, for example ETH) gives the option buyer the possibility to acquire at a certain strike price. There can be two possible outcomes:

1. The asset price doesn't reach the predefined strike price until expiration. The option seller can keep his assets and the so-called premium which is basically the price paid for the option in the first place. Outcome 1) is called “out of the money” (OTM) in financial jargon.
2. The asset price reaches the strike price before expiration. The option buyer can exercise his right (note here he can but is not obliged therefore option). The outcome 2) is called “in the money” (ITM). Note that there is a difference between American style options which can be exercised any time before expiration and European style options which can only be exercised exactly on expiration date.

Put options

The option seller (which deposits a collateral, e.g. USD) gives the option buyer the possibility to sell his asset (for example ETH, BTC) at a certain strike price. Also for put options there are exactly the same possible outcomes 1) OTM, 2) ITM.

Risks

Option sellers are exposed to multiple risks. Options are complicated and managing the correct strike price can be quite difficult. The most obvious risk for the seller is to miss out on possible upside. Especially tricky are leveraged positions. Option buyers on the other hand face only the risk to possibly lose the premium they have paid.