Originally published on November 7, 2018
Hello everyone, this is the second part of the series about options in crypto. In part 1 the focus was on the basics and the most common ways to use options.
In part 2 you will find:
- Basics 2.0: skew and term structure of volatility
- Ways to combine options
- Option price sensitivities
- Special case: what is a “reverse convertible”
When implied volatility for a given maturity is plotted against different strike prices, the resulting shape is referred to as a volatility smile or skew. It shows the relative expensiveness of put vs. call options or how ITM options fare against ATM and OTM options. Here is a longer description, source of the graphs below.
The shape of the curve depends on the market — commodities are different from stocks and FX. For example, skew on longer dated options typically looks like the below. A curve like that shows that put OTM options are more expensive than OTM call options because investors are willing to pay more for downside protection by bidding up options.
Options in commodities have a different skew: when supply gets uncertain, someone in need of a commodity for his business would want to secure it and minimize the risk of disruption — hence bidding up the OTM call options.
Why is skew important? It allows market participants to observe how the options market prices in sentiment, catalysts and fundamentals. Equipped with this information, investors and traders can make use of elevated or depressed volatility to better express their views or to disagree with the options market view.
It is not yet clear whether there should be a “typical” skew in crypto. The folks at Sk3w are showing 3mo skew data on BTC (see below). The “50/150% normalized” basically means that they take the implied volatility of OTM put options and subtract the implied volatility of OTM call options, showing their relative expensiveness. The ratio shows that put options are getting more expensive than call options (or maybe calls got cheaper).
In their latest publication, sk3w offer a revealing comment:
Most of the options selling came from call selling over the last month as investors finally capitulate on a short term bitcoin rally. As a result, the “skew” — the price of puts relative to calls for a given maturity — is starting to rise.
We looked at covered call selling in part 1 as a strategy to generate extra return from the premium if you believe the price will not rise much and implied vol is high enough.
Alternatively, the skew presents a good opportunity for people to buy call options relatively cheap (more on that below).
The term structure compares the implied volatility of options across different expiration dates and usually reflects the market expectations on timing of upcoming important events. In equities, this could be the upcoming announcement of a drug testing results by a pharma company. The stock may be more volatile around this announcement compared to a month earlier or later. As a result, the respective month’s options may be more expensive in terms of implied volatility versus the previous month. Someone who believes that the event may, for example, be less significant or already priced in, may make use of this elevated volatility and sell it vs buying a different less expensive term.
Sk3w have a chart of BTC’s term structure. What it shows is that the options market is not expecting dramatically different volatility between the end of the year and June 2019. November and December look to be roughly as volatile as the 1m and 3m realized volatility for BTC — 30s and 40s respectively.
Now that we’ve seen how volatility differs across strikes and maturity, let’s look at…
WAYS TO COMBINE OPTIONS
Put spreads, call spreads, butterflies, strangles and straddles, synthetic longs and shorts, rainbows and knockouts etc. There are numerous combinations of options with catchy names. However, the important thing to note is that any combination needs to serve the purpose of the investor. Combining options across strikes and terms are well suited for expressing custom views, be it directional, volatility or both.
Let’s take a look at a standard use case: hedge downside risk.
Suppose an investor wants to have downside protection. A simple way is to buy put options. However, we saw that BTC skew is positive, meaning puts are more expensive than calls. Moreover, ATM options (offering protection from current level) are more expensive than OTM options (protection from a lower strike level) in terms of $ cost. Also, knowing that the majority of options expire worthless may have the investor worried of sacrificing a few % of the total position. There are various ways to tackle this issue depending on one’s market view. Let’s look at two:
- Limited upside, significant downside: if the investor believes that the price will not go up much, selling calls to fund buying the puts may make sense. The chart below shows a sample payoff where buying a put ($800 cost) is compared with buying a put and selling a call for a net cost of $200. The investor is sacrificing upside to reduce the cost of the downside protection. This combination (long put, short call) is called a collar in case you’d like to geek out. It makes sense to implement such a construct if call volatility is high relative to put volatility (forward skew). You can also mix maturities in order to take advantage of the term structure. For example, if the investor is worried about a short term downside gap move, buying a put with a nearer maturity and selling a longer dated call may make sense. Longer dated options tend to have higher implied volatility (hence price, all else equal) which could even make the position zero premium, i.e. at no cost to the investor.
- Limited downside, keep the upside: if the investor believes the downside to be limited, he could buy an ATM put and sell a further OTM put in order to reduce the upfront cost. In this case, the investor would be willing to accept no protection below a certain level by creating a protection level between the current price and the short put strike. Mixing the maturities could also help reduce the cost.
These combinations can help traders, funds, miners or exchanges to form views and strategies around events like difficulty changes, forks, launch of new ASIC’s, miners liquidating inventory, futures expiration, reward halving, increases or decreases of velocity, just to name a few.
To complicate matters more, keep in mind that different option combinations may have the same payoff diagram and produce the same directional exposure, but have different volatility exposure. For example, the green payoff line on the Hedge 1 graph above looks the same for: a) long BTC, long put and short call b) long call spread and c) short put spread. However, in terms of vol exposure: a) is initially flat vol b) initially long vol and c) initially short vol. These nuances have implications for traders who mark-to-market their positions and unwind ahead of maturity. I will expand on some of these details in part 3 of the series.
OPTION PRICE SENSITIVITIES
It is interesting to see how certain events have affected the realized volatility of Bitcoin. Please note that these are all known (apart from the CVE bug), previously announced events with unknown price consequences. These are the types of things one tends to play via options as opposed to sudden news which were unknown before. However, the analysis needs to be done in conjunction with data on implied volatility in order to assess when something is priced in.
Practical case: comparing implied with historical (realized) volatility
Plotting 3-month implied vs. realized volatility (data from sk3w for last 20 days) reveals an interesting picture: in the middle of October, the spread was close to 13 vol points which then converged towards the end of October, only to widen again in the first week of November. The price of Bitcoin during the period has been range-bound between $6,350–6,450.
To illustrate the magnitude — an investor could have sold a call option with strike $10,000 expiring in March 2019 on 16-Oct for a theoretical price of ca. $280 per option. During the next two weeks, implied volatility fell by roughly 20 points and the price of BTC — by ca. $100. The same option would be worth below $50 per option at the end of October. Please note that the decline in BTC’s price would have had a limited positive effect (keeping the price the same would give us ca. $60).
Importantly, this is only a theoretical value which comes out of a standard option price calculator. The reality is different. Whomever is making the market would add/subtract their own bid-ask. How much could that be? On the stock market, competition is fierce and vol traders need to keep spreads tight. Crypto vol markets are new, not very liquid and traders can profit quite handsomely. To give an idea, check out the following tweet by skew. on 29-Oct in response to a question by Tuur Demeester about options. Note that they surely meant Mar19 call, not Mar18.
Assuming a market maker would sell the call at $80, it would imply volatility of about 50%. To assess how much vol a market maker would have included in the price, we need to compare it to the implied volatility on the market. Sk3w’s website shows 3-mo vol at 44% on 29 Oct. However, we need 5-mo vol since we are talking about March 2019. The term structure chart shows almost no difference between Dec-18 and Mar-19 maturities so let’s assume (with the caveat that the term structure data depends on liquidity) that 3-mo and 5-mo implied vol is similar at ca. 44%.
We arrive at a spread of 5–6 vol points. It may not sound that much, but if we recalculate the price using implied vol of 44%, the dollar value almost halves, all else equal. In the above case, the price would be ca. $45 instead of the $80 mentioned.
Frankly, the vol premium in this case would not be very different from the premiums that big investment banks include in options sold to their retail clients. In order to allow small investors to buy options on Amazon or Apple in small quantities, the structuring desks of the banks need to include enough premium to allow them to: a) hedge their positions and b) make good money. Historically, banks have made a killing on these products — the more complicated, the better. Next time you decide to buy a double knock-out rainbow option on Apple for $200, it could easily cost the selling bank $50–100 🙂
Which leads me to option sensitivity tables, which are very useful as a guide on pricing at different volatility levels. I’ve used a put and call option price simulation with the following inputs to illustrate:
The difference that volatility levels have on option prices is apparent. However, the key takeaway is that getting the direction matters most. Especially when you take bid-ask spreads into consideration. This is an important element with options — they are not pure volatility instruments.
For example, if you buy a call option for $97.3 and the price drops by 15%, implied volatility would need to increase by 20 points, just for your call to retain its price. And I am not even counting the time value loss, inherent in buying options. Bitcoin is a volatile asset, but these are large moves even considering that.
In part 1, we looked at put selling as a way to get paid to buy at a lower level. There is a product in traditional markets called a “reverse convertible”. It combines put options, stocks and bonds into one structured product. The goal is to enhance the interest received by a debt investor who is also keen to buy the underlying asset at a lower price.
What I find interesting here is that this idea could be adapted to crypto by using options and one of the protocols/services enabling lending like Nexo, Compound or Dharma. One side of the protocol allows people to put crypto as collateral and take out a cash loan. The other side invests fiat and collects interest. I believe a reverse convertible on such a platform would add value and be an innovative product.
For example, suppose an investment fund has cash which it has not invested. Instead of putting it on the money market for little return, they may decide to lend it. Crypto-secured lending rates are currently quite high (10–16% pa) and will surely decline over the next few years with increased competition. If, in addition, the fund wants to go long BTC at a lower price, they could combine the loan and a short put option. If implied volatility increased back to mid 50s/60s, an investor could sell a Mar-19 $5,000 strike put option for ca. 5%. There are two potential outcomes in 6 months: 1/ BTC stays above $5,250 ($5,000 strike + $250 premium) in which case the investor receives 5–8% interest on their cash plus 5% premium from the option for a total of 10–13%. If the price is below the strike, the investor’s principal capital would be converted to BTC at an effective level of ca. $4,750 (ca. 25% below the current price). The chart below demonstrates the outcomes. If the price starts to gap down massively, the investor will face losses.
To be continued…
The second part of the series focuses on option combinations and ways to express tailored views. In the next part, the focus will be on option Greeks and how they affect combinations.
OBLIGATORY DISCLAIMER: This analysis is for illustrative purposes only and does not constitute a recommendation for buying or selling of crypto (or anything else for that matter).
Thank you for reading.