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Comment by Tycho | Hacker News Reader

So... counterparty risk?

A couple of projects have looked at solving the trust issue by implementing a distributed exchange without counterparty risk on top of the bitcoin blockchain: https://www.counterparty.co/ http://www.mastercoin.org/. The idea is that the protocol itself handles escrow and matching orders instead of going through a centralized exchange.

This might be workable with an exchange (there still needs to be trust in the guy holding the USD). However, options markets require margin accounts. It is pretty hard to offer anyone credit without a lot of trust.

For now, steep option seller margin requirements. 100% of the underlying Bitcoin for calls, 20% for puts.

Why 20% for puts? Although loss for puts is capped at 100% of margin value, BTC is as much liable to go up 20% or 20% in a short period of time.

How often is margin calculation done? And what is the time period allowed for option sellers to cover their margin?

Also, what happens if my counterparty can't pay? Is the exchange going to step in and guarantee the trade?

The margin is a percentage of the underlying Bitcoin. So no margin calls.

If your counterparty can't pay, then you get the full value of their margin account for that trade (plus the premium payment, which you already received) and no more.

I see. Let's suppose I own a 1 contract (x100 BTC multiplier) of BTC/USD put contract at strike price $100 BTC/USD when BTC is trading at $100 USD with expiration two months from today (an at the money put). As part of initial margin requirement to enter the trade, the seller has to put down 20 BTC or cash equivalent of $2,000.

Suppose BTC drops 40% in value or $60 in one month, now the notional value of my BTC contract should be $40/BTC or $4,000/contract. Not only does 20 BTC valued at the original value of $2,000 no longer cover the mark-to-market value of my put contract, its market value at $1,200 covers even less that requirement.

Now suppose I'm nervous because I'm sitting on a contract that should be worth 4K when the collateral of my counterparty is only worth 1.2K. Also since I bought a put which means that I'm betting against BTC, that would only make me more nervous about counter-party risk; and I'd demand my counter-party to put up more collateral.

However, if the exchange isn't willing to extract from my counter-party and isn't willing to step in. Then, I have no confidence in such a market.

So only selling covered calls are allowed, in other words?

"Covered calls" are covered by the underlying asset. That's not the same as a 100% margin requirement.

From the call writer's perspective it's indistinguishable from a covered call transaction.

This also greatly reduces the service's usefulness as you are unable to implement many standard option strategies.

The initial transaction, yes, but not the final payoffs.

I agree with you on the other issue (though you borrow money elsewhere to simulate a lower margin).

It seems conceptually crazy to me to buy a put option in such a system where I would be exposed to USD/BTC as well as having no recourse against an anonymous issuer (for 80% of the underlying price).

How do the site's creators think market participants will handle these conditions?

Right now the market can bake those risks into the option prices.

Also, if there is demand for different margin requirements we'll add contracts with those requirements.

It will be pretty interesting to see what spread emerges between calls and puts in these circumstances.

Care to speculate? ;-)

That's the problem with learning all about options before actually caring for the reason they exist: risk management. Options can be replicated with a portfolio, which usually requires a certain minimum size. Investors with a lesser budget would then buy the smaller units of "risk management".

In a way portfolio management through risk diversification isn't free lunch. For example if an investor has $1000 he can't realize a portfolio weight of 10% in a stock that is worth more than $100 per share.

Are you Scott Hansen? Or just a fan of the musician? Just curious.

Neither. Name is from an AI character in a game called Marathon. Which was in turn named for the historical scientist/astronomer.

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