Dopex Essentials – Basic Options Theory (Part 3)

This is the series Dopex Essentials Helps everyone get acquainted with the basic knowledge of Dopex’s pricing mechanism. Part 1 of the series is a simple overview of options and Part 2 delve into some of the more complex areas of options trading.

In part 3, we’ll go back to some basics and discuss some key topics about options trading. The article focuses on two types of options: call options and put options.

Here is the complete list of parts of this Series:

In addition to this series, people can also refer to the following articles to better understand Option Trading and Dopex!

• Huge Growth Potential of Options in DeFi
• Exchange Between Weakhand & Dopex – Leading Options Platform on DeFi (Vietnamese)
• What is Dopex (DPX)? Overview of Dopex Cryptocurrency
• Series 9: Real Builder | Dopex – Growing Amid Difficult Insects

Call Options – Buy Options

Hannah is selling her house for $300,000 in a neighborhood that also has land for sale. Chad and Mario are two people who are interested in the land. Mario plans to develop the land into a beautiful park and botanical garden, while Chad plans to build a low-cost shopping mall.

Another person, Xen, wants to buy Hannah’s house in cash. But unfortunately, Xen doesn’t have enough money for at least the next 3 months. Because of this, Xen is worried that Hannah will sell the house to someone else before Xen has the money.

After that, Xen decided to offer Hannah $10,000 in advance (corresponding to the option premium).If Hannah stops selling the house and gives Xen the option (call option) to buy the house for $300,000 (exercise price), after 3 months (expiration date).

3 months later, if Xen doesn’t want to buy the house, Hannah will take the $10,000 premium and the contract ends. In another case, if Xen decides to buy the house (exercising the purchase option), Hannah still keeps $10,000 and also receives an additional $300,000 from the sale of the house.

There are 3 possible scenarios:

• Scenario A: Suppose Mario buys land near Hannah’s house and builds a park and botanical garden. This development will increase the value of Hannah’s house by $400,000. So by the time the contract expires, Xen will be very excited to buy the house for $300,000.
• Scenario B: Suppose Chad buys land nearby and develops a low-cost shopping center. This development will reduce the value of Hannah’s house by $200,000. In that case, Xen naturally does not want to exercise the option to buy the house for $300,000 but will walk away from the house purchase agreement, losing only $10,000.
• Scenario C: Neither Mario nor Chad bought land nearby. So the value of Hannah’s house neither decreased nor increased and remained at $300,000. In this case, Xen could buy the house for $300,000 or simply walk away from the deal, losing only the $10,000 fee for each option.

Back to the story… Hannah was happy to receive a $10,000 bonus. If Xen does not buy, there is no guarantee that someone else will buy Hannah’s house within those 3 months.

Depending on the circumstances, if Hannah feels the house can be purchased by another buyer sooner than 3 months, she will ask Xen for more than $10,000 to stop selling the house in those 3 months.

That’s an example of a call option, explaining why“the more highly valued the underlying asset is, the higher the premium the market demands for that call option”.

$On the one hand, the buyer of a call option has the right but not the obligation to buy the asset at the strike price on the expiration date. While on the other hand, the seller of a call option, is obligated to sell the asset to the buyer at the strike price if the buyer exercises the option.

For example in the crypto market

If Bitcoin is trading at $50,000 and you expect it to rise to $60,000 in a month (30 days later is expiration). You can buy a $55,000 call option at a cost of $200. If Bitcoin actually increases to, say, $60,000 before the expiration date, the contract will allow you to buy Bitcoin at $55,000 (the strike price) even though the current market value of Bitcoin is $60,000, giving you a net profit of $4,800 per contract.

Meanwhile, the person who sold you the call option would be obligated to sell you Bitcoin for $55,000 and lose $4,800 on each contract.

However, if Bitcoin does not rise above the $55,000 threshold before the expiration date, the call option will OTM and you as the call option buyer will lose $200 in premium and the call option seller will gain that $200.

Put Options – Put Options

Now we will dive into how put options work through the story surrounding Hannah and Xen once again. In this story, Xen is a Wallstreetbets legend who made a fortune thanks to GameStop and Hannah is an insurance broker.

Let’s say Xen owns an Aston Martin DBS Superleggera worth $300,000, He was worried that his car might be damaged in an accident or might be stolen.

Xen decided to buy an insurance policy for the Aston Martin for its full value of $300,000 (This is buying a put option and $300,000 is the strike price). Hannah’s insurance company charged Xen $90,000 is the one-year insurance contract fee (premium), one year is the maturity date.

There are 3 possible scenarios:

• X scenario: Xen’s Aston Martin throughout the following year was never damaged or stolen. Hannah kept the $90,000 premium. Xen lost $90,000 on car insurance that year.
• Scenario Y: Xen’s Aston Martin was damaged in an accident and needed $75,000 in repairs. Xen elected to exercise his insurance policy (his put option) by filing a claim, and Hannah paid him the $75,000 needed for repairs according to the agreement.
• Scenario Z: Xen’s Aston Martin is stolen (possibly by Chad). Regardless, he exercises his insurance policy (put option) and files a claim, but this time for the full value of Xen’s car. So, according to the agreement, Hannah paid Xen the full $300,000 to buy a new car.

Back to the story… In any case, Hannah was very pleased to sell many insurance policies (put options) like the one she sold to Xen. Most drivers never file a claim (never exercise their options), so she records a net profit overall.

If Xen has poor driving skills, selling an insurance policy to Xen will pose more risk to Hannah. So she would have to charge him more than $90,000 for a one-year insurance policy. On the contrary, if Xen is a hard driver, Hannah will charge him less because the risk will be lower.

That’s an example of a put option, explaining why“The higher the perceived risk, the higher the premium the market demands“.

The buyer of a put option has the right but not the obligation to sell the asset at the strike price on the expiration date, while the seller of a put option has the obligation to buy the asset from the option buyer at the strike price if the buyer of the option choose to exercise the option on the expiration date.

For example in the crypto market

If ETH is trading at $5,000 and you believe it will drop to $4,000 in a month (30 days later is the contract’s expiration), you can buy a put option on 1 ETH at a strike price of $4,500 with a premium Premium is $200.

If ETH is below the $4,500 threshold before the expiration date, let’s say ETH reaches $4,000. The contract would allow you to sell $ETH for $4,500 even though it has a current market value of $4,000, giving you a net profit of $300 per contract.

On the other hand, the person who sold you the put option would be obligated to buy ETH from you for $4,500 USD, which is a loss of 300 USD per contract.

If the ETH price does not fall below $4,500 before the expiration date, the put option will OTM, you lose the $200 Premium and the contract seller gains $200.

Introducing Dopex

Dopex is a decentralized options protocol that aims to maximize liquidity, minimize losses for option writers, and maximize profits for passive option buyers.

This article is done based on the combination of Dopex & Weakhand