How to hedge with options: a guide to crypto options hedging

Did you know more than eighty percent of option contracts expire worthless? That’s because options are financial instruments that are mostly used as insurance policies to hedge positions that are too large to unwind. Crypto options hedging effectively provides the best of both worlds, since hedging allows downside mitigation risk while maintaining overall conviction for a specific crypto holding or trade.

Keen to learn how to hedge Bitcoin and other popular altcoin positions? This guide is designed to provide a comprehensive understanding of how to use crypto options for hedging, tailored specifically for beginner traders. By the end of this article, you'll have a clear grasp of how options work, the various strategies available, and how to implement them effectively.

TL;DR

• Crypto options hedging can protect your portfolio during sudden market downturns without fully liquidating your positions, offering peace of mind during periods of volatility.

• Crypto options traders can choose from various strategies based on their understanding of options mechanics, overall market outlook, and personal risk tolerance.

• While far from being beginner-friendly, those new to hedging with crypto options can consider simpler strategies like protective puts and covered calls.

• Hedging strategies involve costs and require a solid understanding of options mechanics. Regularly monitoring and adjusting positions is key to effective risk management.

• Pay attention to Option Greeks to better manage and adjust your hedging strategies based on market dynamics.

What are crypto options?

Crypto options are financial derivatives that give crypto traders the choice to buy or sell a cryptocurrency at a predetermined price before a specified expiration date. Although crypto options are a newer concept compared to traditional financial options, they offer significant potential for managing risk and enabling speculative strategies in the highly volatile cryptocurrency market.

As contracts that are priced according to the underlying crypto asset they’re based on, crypto options can seem rather complex to dive into without first understanding the basics. Here are some terms that go over the fundamentals of what we’ll cover in later sections when it comes to hedging crypto positions and trades.

• Strike price: The price at which you can buy or sell the underlying crypto asset.

• Expiration date: The date by which the option contract must be exercised.

• Premium: The cost of purchasing the option contract.

• Call option: An option that gives you the choice to buy a cryptocurrency at a specific strike price.

• Put option: An option that gives you the choice to sell a cryptocurrency at a specific strike price.

• In-the-money (ITM): An ITM option has intrinsic value. For call options, this occurs when the last-traded price of the underlying asset is higher than the option’s strike price. For put options, this happens when the last-traded price of the underlying asset is lower than the option’s strike price.

• Out-of-the-money (OTM): An OTM option has no intrinsic value. For call options, this takes place when the last-traded price of the underlying asset is lower than the option’s strike price. For put options, this happens when the last-traded price of the underlying asset is higher than the option’s strike price.

What is hedging?

Hedging is a risk management strategy used to reduce or offset potential losses from adverse price movements in an asset. By taking an opposite position in a related financial instrument or derivative, hedging helps limit downside risk while allowing for potential gains. Though it doesn't eliminate all risk, taking such positions in options, futures, or complementary assets serves as a form of protection in volatile markets.

Why is hedging important for crypto traders?

Hedging has gained significant popularity because it allows traders to protect their portfolios from market uncertainty, particularly in highly volatile markets. In both traditional financial markets and crypto markets, price swings can be extreme and unpredictable, making risk management crucial. By taking counterbalancing positions in related assets, traders can offset potential losses and lock in gains during periods of instability. This is how crypto whales and institutions manage the inherent volatility and risk of trading crypto. With the crypto market being notorious for large and rapid price swings, hedging has become an increasingly important tool for crypto traders as it offers a way to safeguard holdings by taking offsetting positions through options, futures, or other related instruments.

For example, in a volatile crypto market, traders with long positions may use options contracts to protect themselves from extreme price declines while still remaining open to potential gains. This flexibility is critical in a market where regulatory announcements, geopolitical events, or shifts in sentiment can cause sudden price fluctuations. Beyond risk management, hedging provides traders with the ability to adjust strategies based on market outlook so they can reduce exposure, lock in gains, or cap losses as needed. While hedging often involves additional costs, it offers a layer of protection that many experienced crypto traders rely on to navigate the uncertainty of the market and preserve their capital. This widespread adoption underscores why hedging is seen as essential in both traditional finance and the evolving crypto landscape.

How crypto options work when hedging

When you purchase an options contract, you pay a premium for the right to trade a specific crypto asset at a set strike price before the expiration date. If the market moves against you and the contract ends up ITM, you can exercise the option to realize profits or mitigate losses. If it’s OTM, your maximum loss is limited to the premium paid.

When hedging with crypto options, traders use these crypto derivatives to protect their crypto holdings from unfavorable market movements or to reduce potential losses during bouts of volatility. As such, you’ll ideally want your options contracts to end up OTM and expire worthless since they’re meant to shield your original holdings from unfavorable price activity.

Struggling to grasp the concept of an options contract as a hedge? In a nutshell, here’s how hedging with options limits your downside risk while still maintaining exposure to potential upside gains in the underlying crypto asset.

1. Purchasing an options contract

As a recap, when you purchase a crypto option, you pay a premium for the right — but not the obligation — to buy or sell a specific coin or token at a predetermined strike price before the option’s expiration date. The premium is the cost of securing this right and represents the maximum potential loss if the option expires OTM.

2. Mitigating losses in unfavorable markets

When hedging, the main goal isn’t necessarily to make the maximum amount of gains. Rather, hedging with crypto options is meant to reduce potential losses in a volatile market.

For example, if you’re holding a significant position in Bitcoin and fear a market downturn, buying a put option would provide downside protection. If the price of Bitcoin falls below the strike price, the put option will increase in value, offsetting losses in your spot holdings.

Similarly, if you’re concerned about missing out on potential gains in a bull market, a call option allows you to participate in upside movements while capping your risk at the premium paid.

3. Letting the hedge expire in favorable markets

If the market moves in your favor, the price of the underlying cryptocurrency moves in a direction that makes the option OTM and potentially worth nothing at expiration.

For a call option hedged against a short position, this would mean the market price of the crypto asset remains below the strike price of the call options, causing the call to expire OTM.

For a put option hedged against a long position, the market price remains above the strike price. This causes the put to expire worthless as it’s OTM.

Benefits of hedging your crypto holdings

Limited risk exposure

One of the main advantages of hedging with crypto options is that your maximum loss is limited to the premium you paid for the option. If the market moves in your favor and the option expires OTM, you won’t be forced to exercise the contract. Instead, your total loss incurred for the crypto option hedge is the premium paid, which acts as a form of insurance against larger losses in your primary crypto position.

This capped risk allows traders to implement strategic hedging plans without the fear of unlimited downside, which is a major concern in unhedged spot positions or in other derivative strategies like futures trading.

Flexibility and strategy

Hedging with options also provides flexibility in strategy. Traders can choose between buying calls or puts based on their outlook and risk tolerance. Furthermore, option strategies like covered calls allow traders to further fine-tune their risk management approach. These strategies enable traders to customize their hedging positions to fit different market conditions and trading goals.

Risks of hedging your crypto holdings

Hedging cost considerations

One of the significant risks of hedging with crypto options is the cost associated with purchasing the options themselves. The premium paid for options can accumulate, especially if frequent adjustments are needed or if the options expire OTM. These costs can impact the overall gains of trading, particularly if the hedged position doesn’t experience significant adverse movements or if the hedge falls apart because it wasn’t properly set up.

Complexity and strategy misalignment

While offering risk management benefits, hedging strategies can be complex and may require a deep understanding of options and their interactions with underlying assets. Improperly executed or misunderstood strategies can lead to ineffective hedging, potentially resulting in unexpected losses or insufficient protection. Additionally, the effectiveness of a hedge depends on the accuracy of the trader’s market outlook and strategy alignment.

Popular hedging strategies using crypto options

Protective puts

A protective put involves buying a put option for a spot crypto holding. This strategy acts as insurance against a drop in the cryptocurrency's price.

How to execute a protective put

1. Identifying your holdings: Determine the amount of holdings you wish to protect.

2. Selecting a put option: Choose a strike price and expiration date based on your risk tolerance and market outlook.

3. Purchasing the put option: Buy the put option to establish your hedge.

Pros and cons of protective puts

Protective puts example with BTC options

Source: TradingView

For the protective put crypto options strategy example, we’ll be taking a look at Bitcoin on the daily time frame. After performing some basic level of technical analysis and making use of the fibonacci retracement tool, we can see that BTC is currently trading in a range on the daily timeframe between the 0.236 and 0.382 retracement levels. As such, if you’re holding a long position in BTC, you could hedge it with crypto options by purchasing a protective put at the 0.236 retracement level, which would be a BTC put with a strike price of about $55,000.

Let’s assume that you’re trying to hedge for the next month as you’re anticipating near-term volatility in the coming weeks.

With an expiry date of October 4, 2024 and a strike price of $55,000, the Bitcoin put contract will cost you about 0.0255 BTC, which translates to about $1,500. By purchasing this put option and running the protective put hedging strategy, this implies that you’re paying a premium of 0.0255 BTC to protect your 1 BTC holding against any potential downside to $55,000. Should Bitcoin continue to rally, the put will expire worthless. Conversely, if Bitcoin suddenly slumps in value, you can opt to exercise your put contract and mitigate the losses incurred from your long BTC position.

Covered calls

A covered call involves selling a call option on a cryptocurrency you already own. This strategy generates income from the premium received while potentially capping your upside.

How to execute a covered call

1. Owning the spot asset: Make sure you have the underlying asset in your holdings to write the call contract against.

2. Choosing a call option: Select a strike price and expiration date based on your personal risk tolerance and outlook of where the market is headed.

3. Sell the call option: By writing the call option contract, you’ll collect a premium and agree to sell the underlying crypto asset at the contract’s strike price if the option is ITM at expiry.

Pros and cons of covered calls

Covered call example with ETH options

Source: TradingView

Let’s now take a look at Ether on the daily time frame for our covered call example. With the same fibonacci retracement tool, ETH looks to be trading between the $2,084.69 and $2,557.71 price levels. If you’re holding an ETH long position and believe that ETH prices will continue to trade between this range, you could consider executing a covered call options strategy. This effectively hedges against further downside while allowing you to generate gains from the call premiums.

By selling an ETH call option with a strike price near the upper end of the range at around $2,600, you agree to sell your ETH if the price reaches that level when the call option expires on October 4, 2024. In this scenario, the premium of 0.0231 ETH ($54.36) received acts as a buffer against small declines in ETH’s price, providing partial downside protection.

However, if ETH breaks above $2,600, your upside potential is capped, as you'll be obligated to sell your ETH at the agreed strike price, even if the market continues to rise. This makes a covered call ideal for traders who are mildly bullish or neutral on ETH in the short term, expecting price consolidation within a defined range rather than a breakout.

Tips to managing your crypto options hedge

Identify your hedging needs

The first step in managing a crypto options hedge is to thoroughly assess your current portfolio and risk exposure. Start by evaluating the size of your holdings, the type of assets you’re holding, and your level of risk tolerance. Are you looking to protect against large market swings, or do you want a partial hedge to reduce volatility in your positions? Also, make sure to consider your market outlook as well. Are you expecting high volatility or a relatively stable market? Understanding your financial goals and risk appetite will help you determine how much of your portfolio should be hedged, and whether you need short-term protection or long-term risk mitigation.

Choose the right crypto option strategy

Selecting the correct options strategy is crucial for effective hedging. Different strategies serve different purposes.

Protective puts are best for crypto traders looking to insure their crypto holdings against potential downturns. By purchasing a put option, you have the right to sell your asset at a specific price, protecting you from significant losses if the market drops sharply.

Covered calls are ideal if you’re holding a long position and want to generate extra gains from your assets. By selling call options, you collect premiums while agreeing to sell your asset if the price reaches the option’s strike price.

Execute the trade

Once you’ve determined the best strategy for your portfolio, it’s time to execute the trade. Use a crypto options trading platform like OKX to place the option order, making sure you fully understand the contract terms, such as the expiration date, strike price, and the premiums you’ll pay or receive. Double-check the details before committing, as small mistakes can lead to unintended consequences, such as overexposure or insufficient coverage.

Monitor and adjust your hedge

Managing a crypto options hedge isn’t a set-it-and-forget-it process. As crypto markets are constantly changing, so should your hedging strategy. Regularly review the performance of your hedge and keep an eye on market conditions that could impact your positions, such as regulatory news or broader macroeconomic shifts. If the price of your underlying asset moves significantly or market conditions evolve, you may need to roll over your options, adjust strike prices, or even shift to a different strategy to maintain effective protection. Being proactive with your hedge can help you capitalize on market movements while minimizing unnecessary losses or leaving yourself underprotected.

Using Option Greeks when hedging with crypto options

When hedging with crypto options, it's helpful to understand and monitor Option Greeks. Named after the Greek letters, the major ones include Delta, Theta, Vega, and Gamma. To briefly summarize, the Option Greeks significantly influence the pricing of each contract’s premium as they take into account factors like the sensitivity of the option’s price to the movement of the underlying asset and the time decay of said contracts. Keeping an eye on these Greeks allows traders to fine-tune their hedging positions and adjust their strategies as market conditions evolve, ensuring their hedges remain effective.

By following these steps and staying vigilant, you can better manage your crypto options hedge and optimize your portfolio’s performance in a volatile market.

Final words and next steps

Hedging with crypto options is an essential skill for managing risk in the volatile world of cryptocurrency trading. By understanding the various strategies and the mechanics involved with each crypto options strategy, you can safeguard your trades and optimize your trading performance. Start exploring these strategies today with OKX and consider incorporating them into your trading plan to enhance your risk management.

Keen to learn more about options strategies that build upon the mechanics introduced by covered calls? Check out our guide to crypto cash-secured puts and the options wheel strategy for more information. Alternatively, you can also read up on our guide to delta neutral options strategies for a more nuanced look at hedging with crypto options.