What are calls and puts?

The building blocks of what compose an option are calls and puts.

Options are designed to be a tool for transferring risk from one trader to another. It is imperative to understand that when buying calls or puts, the potential loss is limited to the amount paid for the calls or puts. When selling calls or puts, the potential loss is unlimited (short puts really have risk limited to their strike price, but are considered unlimited for all intents and purposes). Therefore, when you buy an option, you are limiting your risk by transferring it to whomever sold the option. When you sell an option, you are accepting the risk from whoever bought the option. Options can offer a great deal of leverage, meaning that you can potentially have the risk/reward exposure of a large position in cryptocurrency for a relatively small amount of money.

Calls

Buying a call is perhaps the most common and straightforward option position there is. It's a strategy that's used if you think a cryptocurrency's price will rise and can be seen as a substitute for buying cryptocurrency. Buying a call does offer leverage and limited risk. It usually costs less to buy an option than it does to buy the underlying cryptocurrency, and is generally considered less risky than a position in cryptocurrency. But you have to be confident that the cryptocurrency price will rise sufficiently before the expiration date of the option. Options expire, cryptocurrency does not. You can "hodl" cryptocurrency and hope that eventually it will rise in price. You can't do that with a call option. If the cryptocurrency price doesn't rise enough by a certain date, the call option may expire worthless or with a lower price than you originally paid. So, it's not enough to be bullish on a cryptocurrency in order to figure out which call to buy.

The key is that there are trade-offs between potential risk, the probability of profit, and the potential profit. Generally, the lower the risk or the higher the probability of profit of a trade, the smaller the potential percentage profit. It's highly unlikely that, in a lifetime of trading, there will be massive potential percentage profits that are all but guaranteed to happen with little or no risk.

You have to balance these trade-offs. For example, an option's value is continuously whittled down by the passage of time. There is a constant battle between the erosion of your option's value as time passes and waiting for a favorable move in the cryptocurrency price or an increase in implied volatility that will push the value of the option back up. Therefore, you need to consider the timing and the magnitude of the anticipated rise in the cryptocurrency's price. Each one of these is a speculation that you are accepting when you trade options.

You also have to decide whether to buy a call with more or fewer days to expiration. An option with fewer days to expiration has a couple things going for it. First, all other things being equal, it's cheaper than an option with more days to expiration. That means you'll have a smaller absolute loss if your speculations are incorrect. Second, all other things being equal, if the cryptocurrency price moves up, it will probably have a greater percentage increase in value than an option with more days to expiration. So why ever consider an option with more days to expiration?

Well, options with more days to expiration have their advantages. First, there's more time for the cryptocurrency to make a favorable move. For a given level of volatility, a cryptocurrency will have a chance to make a much greater up or down move if there is more time. There will be a greater opportunity for the cryptocurrency to rise sufficiently and/or recover from any price declines in order for the call to be profitable. You don't want the cryptocurrency to make its big move the day after your options expire. Second, an option with more days to expiration will experience less price erosion as time passes, and have a smaller percentage loss if the price of the cryptocurrency remains unchanged or falls.

Changes in implied volatility affect options with more or fewer days to expiration differently. Calls with more days to expiration are more sensitive to changes in implied volatility than are calls with fewer days to expiration. You have to remember that implied volatility can move up and down, and can have negative results if it moves against you.

Remember, you never get anything for free.

Whether to buy an ITM (in the money), ATM (at the money), or OTM (out of the money) call is another decision you have to make because each of them responds differently to changing conditions. An ITM option acts the most like a cryptocurrency position. Depending on how deeply it is ITM, it will act more and more like cryptocurrency. It will be affected less by time and changes in volatility, and more by the cryptocurrency price moving up and down. An ITM call may require a smaller rise in the cryptocurrency price to be profitable, but its percentage gains won't be as great as those of an ATM or OTM call.

An ATM option has the greatest uncertainty. It is the most sensitive to changes in the cryptocurrency price and volatility, and time passing. This can be good or bad. If all your speculations are wrong, the ATM option can hurt you the most.

An OTM option begs for a very large rise in the price of the cryptocurrency. If you get a big enough move in the cryptocurrency, an OTM call can deliver a much higher percentage profit than an ITM or ATM call. And if the cryptocurrency price falls dramatically, the loss on the OTM call will be smaller than on an ATM or ITM call. But remember that a big move in the cryptocurrency price is less likely than a smaller move, and OTM options will expire worthless if the move in the cryptocurrency isn't big enough.

Selling a call is the mirror image of buying a call. It's a speculation that the price of the cryptocurrency will fall, stay the same, or rise only very little. You have to consider the same things as when buying a call, except in reverse. Where a long call loses money, a short call makes money. Just remember, a short call has limited profit potential in exchange for unlimited risk if the cryptocurrency decides to skyrocket.

Puts

Buying puts is a strategy that profits from a drop in a cryptocurrency's price. The only practical difference between buying puts and buying calls is that you want the cryptocurrency price to go down if you buy a put, and up if you buy a call. The decisions about days to expiration, volatility, ITM, ATM, and OTM are all basically the same for a call and put.

Buying a put is an effective alternative to selling cryptocurrency short. Short cryptocurrency can have high margin requirements, and some brokers restrict their customers from shorting cryptocurrency. Unlike short cryptocurrency, buying puts has limited risk, but like short cryptocurrency it has unlimited profit potential. Strictly speaking, the potential profit on a long put is the dollar value of the strike price of the put minus the premium of the put – it is not infinite.

Selling a put short is the mirror image of buying a put. Like a short call, a short put requires you to assume unlimited risk. Like the potential profit on a long put, the risk of a short put is the value of the strike price of the put minus the premium of the put. Because a cryptocurrency can never have a value less than zero, the potential loss on a short put can be very, very large, but it is not infinite.

When trading options, you have to refine your speculation to incorporate how much you think the cryptocurrency may move, how much time it will take for the cryptocurrency to move, and how implied volatility might change. Understanding the trade-offs in options can help you understand how and why your option position is acting the way it is.

NOTE: This is a living document that will continue to be updated as SIREN evolves. To contribute, please visit SIREN on GitHub. Specific questions may be answered and technical guidance may also be provided from time to time in the SIREN Telegram to those who are interested in building on top of the protocol.