How options work?
To start interacting with options one should first choose between the following basics characteristics of an option contract:
Type of right: put (right to sell) or call (right to buy),
Type of exercising: American or European,
Type of settlement: cash or physical.
Once that is decided, one should pay attention to the following details:
Underlying asset
Strike price
Strike asset
Expiration date
Premium
The underlying asset is the object asset, the asset people want to have to right to either buy or sell in the future.
The strike price is like the trigger price. Is the price that informs to both counterparts that the agreement can be exercised.
The strike asset is the asset that will be delivered in return to the underlying asset upon expiry.
The expiration date informs for how long this contract is valid.
The premium is the current market price of an option contract. It is the income or reward that the option seller gains in order to write and sell the contract. And thus, the price that the option buyer pays to the seller so that it can hold the contract until expiry. The premium is paid upfront.
Pricing
There are several models for pricing options in tradicional finance and the most widely know is Black-Scholes. Black-Scholes is a mathematical model for pricing an option contract and this model assumes, among other things, that the asset's volatility remains constant over the option's life (which is not applicable - specially in crypto). The formula is applicable only to European options (and to American calls on non-dividend paying assets).
The mathematical notation of it is:
Other models are also commonly used, such as the binomial model and trinomial model.
But another deal breaker here is that most models use the risk-free interest rate (generally, US treasuries rates) to estimate the premium. It is hard to do it in the crypto environment, though.
Evaluating an option
After an option is issued and sold, the holder of the option will analyze certain market conditions in order to make a decision whether to exercise it or not.
We say that an option is in-the-money if the event of exercising it will incur in a positive payout for the option holder on both cases, puts and calls. For instance, being in-the-money for put option means that spot price (current market price for the underlying asset) is below the strike price. Meaning, if the option holder (user that bought a put option in the past - holding the right to sell the underlying asset at strike price upon expiry) exercises, it will sell the underlying asset for a price (strike price) that is currently higher than the spot price. In the case a a call option, being in-the-money means that the spot price is higher than strike price.
On the other hand, we say that an option is out-of-the-money when opposite occurs. In other words, when it makes no sense for the option holder to exercise the option.
So keep in mind that to evaluate the worth of an option, one should always be compare the spot price and the strike price of the underlying asset, giving the option type.
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