Options Strategy

My Introduction to Options

This week I want to talk through my current strategy and thought process and how I am approaching my options trades. There is a growing interest in the chat room about using options and personally, I find them to be a much more relaxing and cool headed approach for my investment style. I will share with you my experience and strategy trading on Deribit so far as well as the watch-its and mistakes/lessons I have learned.

BIG FAT DISCLAIMER: I am not a TA wizard nor am I a good directional trader. I am a fundamental investor who knows what charts look like and I focus more heavily on how I manage risk. Please do not follow anything here as advice, use it as a springboard to research and learn at your own pace.

Why I trade options

First, I don’t have time to look at charts all the time and most of the time I am wrong on the micro scale for my entries.

Second, I am a big picture thinker, I like macro rather than micro. I am far better at picking large scale shifts in the market which is why I gravitate towards on-chain analysis. I don’t know when its going to pull back but I believe it will.

Third, selling Options fits neatly into my strategy of accumulating as much BTC as humanly possible. Coupled with my DCA approach, I have been effectively buying BTC at a 30-50% discount since April by selling puts below the Realised Cap in the accumulation zone. This is a fundamental trade strategy which works for my style.

Tools and references

To start off, I found this spreadsheet which is pretty much ready to go out of the box for pricing options and building strategies. It runs on Macros which print the Call and Put charts that helps you build positions and understand how combinations of options work. 

The underlying theory is the Black Scholes theorem which I understand to be a very widely used (and probably misused pricing method). What is nice is that the market makers on Deribit DEFINITELY use this pricing model so you will get a very good reference to what the option is priced on the market.

The spreadsheet is setup for stocks and since Deribit is priced in BTC, it will need some slight modifications. Happy to discuss on Discord if needed.

https://www.exinfm.com/excel%20files/OptionTradingWorkbook.xls

The second reference is Doc. He’s the dude. You can do as much reading as you want, but I recommend nagging him in the chat room and on trade schools – you will learn the most this way for sure.

Lessons going in

Lesson 1 – Options are expensive.

The options on Deribit are 10x leverage and each contract is worth 1BTC. That means that to open a full contract you need a minimum of 0.1BTC margin. You can buy/sell 0.1 contracts as the minimum size which requires 0.01BTC as margin and is what I trade.

When you buy a contract, you pay the price shown on Deribit. BTC options are expensive but liquid. I only sell BTC options. Conversely Ethereum options are comparatively cheap. I usually buy ETH options as a contrarian trade because it is more volatile and right now is following BTC but with larger swings.

When you sell an option you get paid the premium if the contract is worthless at expiry. Selling requires 0.01BTC per option as initial margin.

Now you will need additional margin to keep your position open. Lets say you buy 0.1contract with 0.01BTC margin. If the market goes against you and the price of the option is now more than what you sold it for. Deribit now thinks you are underwater – you must always have a balance large enough to MARKET STOP out of your position. 

My strategy, is that for every 2x 0.1 Contracts I open, I MUST have 0.03BTC in my account. Ie. 3x margin for 2x position (33% buffer). 

Lesson 2 – Pricing in BTC is weird and dangerous to the downside.

Deribit prices everything at the current Index price of BTC. That means that the lower BTC index price goes, the more BTC you need to cover your losses to the downside. Example

$100 when BTC is $10k = 100 / 10,000 = 0.001 BTC

$100 when BTC is $8k = 100 / 8000 = 0.125 BTC (25% more BTC lost)

Any time you are underwater because BTC index price moves down, your required margin and potential losses in BTC go parabolic very quickly. This is why I have a 33% buffer, my position could be the best trade of all time…but if the MARKET exit price exceeds your margin available, you get liquidated. Don’t risk it.

Think of it this way – all your debts are denominated in BTC. If BTC is less valuable, you need to use more to pay your debts. An example Profit and Loss chart for selling a Dec 7.5k Strike price Put is below. You will see that the losses in BTC accelerate and go parabolic to the downside where as USD is linear. 

Lesson 3 – market makers

The large size bids and asks you see are market makers. They have a fairly wide spread but generally agree with the Black-Scholes equation in the spreadsheet I linked before so are fairly easy to check what is a ‘fair price’.

There is a relatively small number of actual traders but that doesn’t stop you from executing your strategy. Just be very aware that when you enter an option trade – you immediately have a price against you if you needed to exit as you need to jump the spread gap to close it. Choose your entries wisely and use volatility as your edge.

Lesson 4 – When you are wrong, you know it

The combination of Lessons 1 to 3 means that if you get your entry wrong, you very quickly have a large target on your forehead and it can be very stressful. 

When you Sell an option at the wrong time (i.e. when BTC market is quiet) and suddenly it gets volatile and price goes against you…red. So much red. Your whole account will scream red. Its brutal. Note that I have never ever had price breach one of my sold puts strike price. It’s come close but never broken the level. Doesn’t matter, the price for me to market exit screamed so high…it just goes so red…Always have buffer in your account and always sell into strength and volatility.

Lesson 5 – Learn about Options

Start reading, listening and learning. The more you play around with the spreadsheet the more confident you will become. This is what I did, I made up positions, changed volatility and manipulated the spreadsheet to suit my needs. 

Also, here is a nifty cheat-sheet I made whilst learning.

Summary of Lessons going in

The single most important lesson I have learned is that you need to be bold and contrarian to sell options. This is why the CHOP index and divergences are your best friend.

Selling options is all about taking someone else risk when they are rushing for the exit, but you are calm and confident that your level is safe and low probability of being tested.

Summary of my strategy

It’s pretty simple.

Step 1 – Dollar cost average 50% of my dirty fiat ? Deribit, the rest cold storage after entering when I see edge in the charts.

Step 2 – Sell options by the following strategy:

Covered Calls: Where you sell a Call above the price but own the asset. If price closes below that strike on expiration, you keep the whole premium. If price keeps going up, you pay the piper. This is a bearish trade and I only do it for short dated options (<2 weeks because it’s a bull market and I ain’t shorting Bitcoin for long). You don’t want to be wrong here because Deribit is cash settled, you owe BTC.

Signal ? Weekly exhaustion signal + On-chain lack of volume = a good time to sell Calls above the price (I sold them at 15k above volume profile node during the run up).

Covered calls are ok, and quick wins (short dated) but the real winners comes from…

Selling Puts: Where you sell a put below the current price with the best timing being during a strong pullback. So long as price remains above this level at expiration, you pocket the premium.

Signal ? Strikes below the Realised Cap = Great place to sell Put options on massive angry pull backs. I believe it is very unlikely that BTC will fall back below the Realised Price as too many smart people will buy it before then. I watch for bullish divergences and exhaustion to the downside on the Daily chart to enter. I usually Sell Puts + Buy the rest of my 50% allocation of dirty fiat at the same time – Bullish trades.

I usually sell the December Put options around 5.5k to 6.5k strike price (with occasional risky 7k now that price is higher). They carry a significant time premium plus if you land a sell during a big pullback, premiums rocket higher. If you get this strategy right, you can take home >100% of your margin in premium which means that BTC I bought at $10,000 now has an effective purchase price at $5000. Half price BTC.

Risks

I will focus on selling puts as this is my main strategy regarding how I manage risk. This may not be the ideal or best risk management solution and how you manage risk is up to your personal tolerance and management strategy. It would be different for physically settled options.

I know that if price tanks and really starts to challenge my strike levels, the price to market exit will be astronomical. The options with strike prices above $6,000, I have calculated using my spreadsheet at what Index price the Black-Scholes market maker would be acceptable loss for me to exit. It will hurt but it is necessary. I also will wait until price is at the end of a consolidation to exit to avoid paying a massive volatility premium.

For the strikes below the realized price (currently at $5,500), I will not exit these. If BTC gets below this level between now and December, we will have bigger problems to deal with in the market. If this occurs, it will either be for a short time OR it will be so dramatic that my account will be wiped out anyway (a loss I am mentally ok with).

So I have a balance of margin sitting at the ready in a secondary account (you can have sub-accounts on Deribit). I will pull this out and open up a short position for the full amount of my options obligations. i.e. If I have 0.2x Put contracts sold at 6k, and price breaches 6k, I will open 0.2x $6,000 =  $1,200 worth of short futures positions. In this way, any downside risk I am exposed to on my option will be equalized by the short futures position. It’s not an elegant solution but neither is BTC back at 6k. Would be both a dream and a nightmare.

Closing thoughts

That is pretty much my entire trading strategy. I have found that after many months of being wrong with small bets and fiddling with that spreadsheet, I gathered enough momentum, ideas and lessons to execute what has so far been orders of magnitude more profitable for me that futures. Options are big picture and suit my style. Plus, we have Doc the wizard on hand so use his teachings to the fullest.

If in doubt, play around with the Ethereum options. They are much cheaper so even if you dedicate $50 worth of ETH to test the waters with short dated options, it will be worthwhile. The best way to learn these dynamics is by doing and it becomes less weird with experience.

I have lots to learn but my account is pleased with the switch.

Good Luck

CM