Options and Leverage Trading

Leverage trading is a popular strategy among traders seeking amplified returns, especially in the volatile crypto markets. However, with high rewards come significant risks. Liquidations are common in futures trading, often resulting in substantial losses. For instance, on August 5, 2024, a significant market decline led to the liquidation of nearly 300,000 crypto traders from their leveraged positions or collateral trades, according to data from Coinglass. Reference

Disclaimer:

This article is purely instructional and is not financial advice. Long options trading comes with strategic advantages and risks, including the potential loss of the entire premium paid. While long options avoid the liquidation risks associated with futures, if the option expires out of the money, the premium is lost. Additionally, shorting options carries significant risks and is not discussed in this article.

The Dangers of Leverage Trading with Futures

Let’s use Deribit as an example. On this platform, the initial margin for futures leverage trading starts at 4%, allowing traders to leverage up to 25x their capital. While margin requirements increase slightly with position size, we’ll ignore that for simplicity.

Imagine you open a BTC futures position at $56,000 with 25x leverage. The initial margin required would be:

$$\text{Initial Margin} = 4\% \times 56,000 = 2,240 \, \text{USD}$$

So, you need $2,240 to control a $56,000 position. Now, if the price rises to $64,000 (a market increase of 14.2%), your profit would be:

$$64,000 - 56,000 = 8,000 \, \text{USD}$$

This results in a net profit of:

$$\frac{8,000 - 2,240}{2,240} = 257\%$$

This example demonstrates the appeal of leverage trading—large returns with relatively small initial capital.

However, the maintenance margin for the same futures contract is typically 2%. This means that if the BTC price drops by just 2%, your position could be liquidated, resulting in a 50% loss on your initial investment. In the highly volatile crypto markets, a 2% price swing can occur within minutes, making leverage trading particularly risky. To mitigate this risk, it's crucial to set stop-losses or implement other risk management strategies.

The Power of Options in Leverage Trading

Now, let’s explore options—a more flexible and controlled way to leverage trades. While traditionally used for risk management, options also serve as powerful tools for speculation, offering both better control over downside risk and the potential for upside gains.

On platforms like Deribit , going long on an option means the only capital at risk is the premium you pay upfront. Unlike futures, there are no margin requirements, so liquidation is not a concern, even if the market moves against you. This provides traders with greater peace of mind while still offering the opportunity for significant returns.

For example, let’s say you purchase a 6-month call option with a $60,000 strike price while the spot price is $56,000. This option gives you the right (but not the obligation) to buy BTC at $60,000 upon expiration. However, you don’t have to wait until maturity to benefit—you can sell the option at any time. If the market moves in your favor, meaning the BTC price increases, you can lock in profits without needing to wait to exercise the option.

The option premium is influenced by factors such as implied volatility $(\sigma)$, time to maturity $(T)$, and the underlying asset price $(F)$. A simplified formula to estimate the premium for an at-the-money (ATM) call option is:

$$\text{Premium} \approx 0.4 \sigma F \sqrt{T}$$

This formula gives a quick approximation of the option premium, highlighting the importance of volatility, time, and asset price in determining the cost of the option. For instance, with an implied volatility of 50% and a 6-month maturity, the premium for an ATM call option on BTCUSD might be:

$$\text{Premium} \approx 0.4 \times 0.5 \times 56,000 \times \sqrt{0.5} = 7,919 \, \text{USD}$$

This premium is much cheaper than buying the underlying asset outright. Additionally, purchasing an out-of-the-money (OTM) option (e.g., a Call option with a strike price of $60,000 when BTC is at $56,000) offers an even cheaper premium while still providing leveraged exposure to price movements.

Options provide leverage through their premium structure. For at-the-money (ATM) options, the leverage factor is inversely proportional to $\sigma\sqrt{T}$. This means lower volatility $(\sigma)$ and shorter time to expiration $(T)$ offer higher leverage. This principle applies broadly to all options—lower volatility and shorter time horizons generally provide higher leverage, but they also come with increased risk due to the shorter time window for the trade to move in your favour.

If the option remains out-of-the-money (OTM) by expiration, the buyer loses the entire premium. However, if the option goes in-the-money (ITM) (for example, if the spot price rises above the strike price for a call), the option holder can make substantial profits. Importantly, the trader does not need to wait until expiration and can unwind the position at any time, locking in profits before maturity if the market moves favourably.

Scenario Comparison: $50$ vs. $70$ Implied Volatility

Below are two tables comparing different scenarios at 50% and 70% implied volatilities. The option buyer purchases a call option with a strike price of $60,000 when the spot price is $56,000, with maturities ranging from 2 days to 1 year. The tables illustrate how the option's value changes if the spot price drops by 2% to $54,800 (where a leveraged future would suffer a 50% loss due to liquidation) or rises by 14% to $64,000 within a 1-hour timeframe for simplicity of the example.

Evolution of a Call Option bought at spot = $56K under different rapid market scenarios (spot drop of 2% to $54.8K and sharp increase of 14% to $64K)

Key Takeaways

As shown in the tables, higher volatility provides lower leverage but also reduces the losses. The potential gains for short-tenor options like 2-day options are significant but come with high risk, as the likelihood of hitting the target price within such a short time is low.

Longer maturity options, on the other hand, allow more time for the market to move in your favour, offering a safer approach. The user can give the option time to recover losses and see the trade hypothesis play out.

With options, the trader is not worried about liquidation and retains full control over the strategy. Choosing the right maturity, strike, and understanding volatility levels provides flexibility in managing risks and rewards. A good strategy is one where the hypothesis is satisfied fairly quickly and allows the trader to exit with high gains without sticking too long in the option position and seeing the value eroding due to time decay.

An example of strategy and performance

Since March 2024, BTC has been ranging between $50K and $70K. In this signal generation, we use simple technical analysis to detect a possible trend for leverage trading using options. Let’s use Heikin Ashi on daily candles. Heikin Ashi is a type of candlestick chart that smooths out price data and highlights market trends by averaging price movements. Unlike traditional candlesticks, Heikin Ashi reduces noise in volatile markets, making it easier to identify trends and potential reversals.

A basic strategy is to go long once the daily chart switches from red candles to green candles, following the close of the first green candle.

Daily BTCUSD Heikin Ashi candles. Simple strategy: Go long on the first green candle close, short on the first red. To increase likelihood of success filter signals with Bullish/Bearish divergence of RSI only.

Visually, this strategy would have produced several winning trades and only a few minor losses. To increase the likelihood of winning, we add a powerful indicator: the Relative Strength Index (RSI). We go long only when a bullish reversal is detected. Using TradingView and our data, we observe the closure of a first green candle on 10th September 2024, following a series of red candles, alongside a bullish RSI reversal (i.e., lower lows on the price with higher lows on the RSI). The combination of these two events suggests a probable new positive trend, with an estimated likelihood of over 50%.

This is a simple example for illustrating option leverage. Traders can apply their own rules to detect trends or market moves.

On 10th September 2024, BTC’s price at candle close was around $56K, consistent with our earlier analysis. Based on this, we decided to go long with two out-of-the-money options: one with a short expiration of 18th October 2024 and another with a longer expiration of 25th June 2025. Both options, available on Deribit, have a strike price of $60K.

The results are shown below.

3-hour BTCUSD candles post-10th September: Orange curve shows the evolution of a $60K call expiring 27th June 2025, and light blue curve shows the evolution of a $60K call expiring 18th Oct 2024.

Looking at the long-dated option, where market volatility (orange curve) is around 64%, as BTC rises from $56K to $64K between the 10th and 24th September, the option generates a net profit of 42%, offering a leverage factor close to 3 (42% profit compared to BTC's 14% price increase).

On the other hand, the short-dated option delivers an impressive 185% profit, translating to a leverage factor of 13 relative to BTC's price movement. These results align well with the approximation tables provided earlier, highlighting the potential for significant gains with shorter-tenor options.

Conclusion

In summary, while futures offer substantial leverage, they come with constant risk of liquidation. Going long options, on the other hand, provide more complex leverages with several degrees of freedom and offer a great variety of strategies with no risk of liquidation, making them a smarter choice for traders who want to maintain flexibility and control over their capital.

Long options still carry significant market risk, and the total loss of the premium paid can occur; therefore, a proper understanding of the risks involved is crucial.

In volatile markets like crypto, options give traders the time and tools to manage risk better while still benefiting from price movements.