6. Protective Puts

We all know that the prices of cryptocurrencies are highly volatile, and investing in them comes with high risks. If we only buy the futures or spot, we may face significant fluctuations and risks of losses. In such cases, investors can use options as a tool to control the risks of futures or spot investments. By buying options along with underlying assets, investors can achieve profit protection and prevent excessive losses.

Scenarios

1. You expect Bitcoin (BTC) to rise and want to buy futures, but are worried the market will fall after you buy them.
2. You currently hold BTC and have gained a good return, but want to retain the potential for further gains while protecting your current gains.

This strategy is suitable for those who are optimistic about the underlying asset in the long term, and therefore want to buy an insurance policy.

Description

The option insurance strategy, also known as the protective put option, is when an investor buys a corresponding number of put options while holding the underlying asset.

Option Insurance Strategy = Holding the Underlying Asset + Buying Put Options

Example

Suppose we bought one BTC at a price of $25,000 and bought a put option with a strike price of $25,000 (at the money) for $500 (the premium).

• If the BTC price rises on the expiration date, the put option will become worthless, but the spot asset will generate profits.
• If the BTC price falls on the expiration date, you can still sell the one BTC you hold for $25,000, which is higher than the market price, thereby offsetting the loss caused by the spot asset's decline.

Trading example: (ignoring transaction and exercise fees for calculation convenience)

On March 24, 2023, we bought one ETH at a price of $1,810 and bought a put option on Coincall for ETH-31MAR23-1800-P, with a premium of 55 U.

That night, the market experienced a significant fluctuation, and the ETH price dropped to $1,703. The price of the put option we purchased increased by 233.2%, and we chose to close the option and sell it for a profit of 55 x (233.2% - 1) = 73.26 U.

At the same time, because the ETH price fell, we lost money in the spot asset, with a loss of $107 = 1,810 - 1,703.

Profit from option: 73.26 U

Loss from spot asset: 107 U

Total loss: 33.74 U

Therefore, if we did not buy the put option, our loss would have been 107 U. However, by buying a put option to insure the spot asset, the actual loss was only 33.74 U. Of course, we could also choose not to close the option and continue to hold it for insurance purposes.

Advantages

Compared to just holding a spot position, the main advantage of the option insurance strategy is that it "insures" the underlying asset. Once the market drops or corrects, as demonstrated in the example above, the investor can use the purchased put option to make a profit and offset the losses from the spot market, or even lock in previous gains.

For example, if an investor has a positive long-term view of BTC and expects the price to rise to $100,000, they might have bought one BTC at $45,000. However, if the price drops to $28,000, the loss would be $17,000, and there may not be enough funds available to buy more BTC. In this case, by allocating a small number of funds to purchase a put option when buying the spot BTC, the investor can construct an insurance strategy that not only offsets losses from the spot market but also may result in positive gains.

Extended

Using Collar Strategy to Reduce Insurance Costs

Since insurance strategies require paying a premium, the cost may be too high. In this case, we can choose to use the collar strategy to reduce the overall cost of the combinations. That is, in addition to the original insurance strategy, add selling out-of-the-money call options to receive income from the premium and reduce the total cost.

Collar Strategy = Holding the underlying asset + Buying put options + Selling call options

The collar strategy locks in the downside risk of the underlying asset with an equal amount of put options, while the sold call options can further reduce costs. The downside is that if the underlying asset experiences a significant increase, the sold call option will become in-the-money and be exercised, resulting in a loss of potential profits from further increases. The collar strategy is essentially an extension of the insurance strategy, which can hedge the downside risk of the underlying asset while enhancing returns.