Options & Cryptocurrencies: A New-New Frontier
Introduction
Options are a well-established product in traditional financial markets and can trace their roots back to the very beginnings of commerce. However, it wasnt until 1973 that the Chicago Board of Options Exchange (CBOE) began trading standardised option contracts on exchange. We believe 2019 will be the year where truly exponential growth of cryptocurrency options began. With bitcoin and the broader digital asset sector gaining ever increasing traction and popularity, it is no surprise to us that more complex derivatives markets have begun to grow around the physical/spot market. With both base volatility levels and volatility of volatiltiy so much higher than that of traditional assets and unlikely to change any time soon, this asset class is uniquely suited to the development and trading of options products.
The first derivatives widely offered over bitcoin came in the form of perpetual swaps and futures, such as those offered by Bitmex and the CME. This market has grown rapidly, and now far outstrips the physical market volumes on any given day:
Unsurprisingly, with this growth we have seen numerous new players such as Deribit and CoinFlex enter the market with their own offerings which should, over time, lead to increasing competition.
As a new type of asset, it seems obvious that derivatives that cater to bitcoin’s specific differences will grow around it (e.g. derivatives of hashpower/difficulty such as those being developed by BitOoda) as will more complex derivatives like those you find traded by sophisticated parties in the regular markets. These would include various types of swaps and options spanning both over-the-counter/listed and vanilla/exotic. With a deep background trading these types of products, we believe options will be the next area of real product growth within the digital asset market, and that this growth has only just begun. This will bring with it numerous opportunities both from those using options to hedge positions, those providing liquidity to market participants, those seeking to extract alpha from a new and growing product and those building infrastructure around it. This article will touch on the basics of options & volatility trading and the development of the cryptocurrency market.
The Cryptocurrency Options Market
The cryptocurrency options market has increased rapidly since late 2018, with unreported Over-the-Counter (“OTC”) volumes also easily exceeding current growing exchange volumes. Below we can see the growth in BTC options volumes at the largest exchange currently in operation, Deribit:
Given our strong conviction that eventually the bitcoin derivatives markets will closely mirror that found in traditional markets, it follows that options trading volumes will eventually be significantly larger than the volume of linear, physical products. As an experiment, if we combine Deribit June volume, Ledger X June volume of USD$47mn (as per data from Skew) and assumed OTC volumes, we could estimate June total bitcoin options volume (USD) as USD$4bn. Compared to this, physical volumes over a 30day period from late June to July as a comparison are approximately 4.29mn bitcoin (from bitcoinity.org), or USD$45bn at a market price of USD$10,500. This shows that conservatively (by not accounting for growth in physical exchanges, the size of linear derivative markets or options on other cryptocurrencies) we should expect a greater than 10x rise in cryptocurrency option volumes from here.
Counterparties are critical to any full functioning market and in established traditionals market you see both multiple trading venues and multiple trading parties. For example, regarding trading venues:
Liquidity providers and trading venues in traditional options markets are extensive, while limited in cryptocurrency options. We beleive this is another area where growth will be strong. In terms of OTC counterparties, Akuna Capital, QCP Capital, Galaxy Digital and OSL are all making options markets and there are several other firms making electronic markets on exchange, such as XBTO. Exchanges are currently limited to Deribit, Ledger X and Sparrow. However, other exchanges are in in development such as one being developed by Skew and we believe traditional exchanges like CME will list bitcoin options in the next 12–24months.
Currently, all over-the-counter options are being traded bilaterally (each counterparty settles, faces and margins with each other), with no clearing house or margining facilities available. This is one clear area for ‘traditionalisation’ of the market to occur, and unsurprisingly it is. Paradigm are developing an automated trading chat for institutional traders (like a Bloomberg IB or Symphony chat), with block trading and RFQ (request for quotes) available. CORA Network are working to develop the OTC crypto market in a range of ways, while X-Margin is a distributed clearing house that allows cross-margining across multiple OTC partners and trading venues using zero knowledge technology.
Given all of the above, we expect the digital asset options market to flourish, bringing with it increasing opportunities for those positioned both to grow with the asset class and with the expertise to take advantage of trtading opportunities as they arise. As digital assets continue to gain adoption and traction in a broad sense, combined with the development and growth of the options markets as outlined above we will see options liquidity in more complex products and over more coins and tokens. Already OTC options markets have periodically appeared in LEO, BNB, XRP and BCH, GSR is offering variance swaps and Algorand’s auctions feature a built in put option (effectively functioning as a puttable convertible).
Some Options Basics
Without delving into the mathematics or technical aspects of options pricing and trading, it is important to gain a broad understanding of what options are and the ways in which they can be traded. Options trading can be seperated into two main categories: directional and non-directional, being aware that there is always going to be crossover between these broad categories (for our purposes we will assume all option positions below are long and thus long volatility). For those looking for a primer on what an option is, there are numerous free resources available on the internet such as Investopedia (https://www.investopedia.com/terms/o/option.asp).
Directional Options Trading
Simplistically, this would involve buying calls if you expected the market to go higher (and eventually settle above your breakeven point, calculated as option strike + option cost) or buying puts if you expected the market to go lower (and eventually settle below your breakeven point, calculated the same as for calls). A call option allows a bullish investor to gain leveraged exposure to a rally in bitcoin, as for a low upfront amount of premium outlaid, one can gain exposure to significantly more BTC if the market price moves through the trader’s option strike price (and vice versa for puts).
While simple long-calls or long-puts are the cleanest example of directional options trading, there are a multitude of other strategies that can be employed. Furthermore, to truly get the most asymmetric and effective directional exposure, you must look at other more technical aspects of options pricing which are beyond the scope of this article, but include term structure, option skew, implied volatility and option smile.
Non-Directional Options Trading
As opposed to having a directional market view and placing an options trade around that, non-directional options trading’s most basic premise is to extract value from volatility as an asset class. This means that if the trader expects volatility to be greater than the market is implying over the life of the option, they should be long options or long volatility (and vice versa if the trader is bearish volatility). The cleanest example of this is to be long a delta-neutral straddle, which is to be long a put and call at the same at-the-money strike and the same maturity. By implementing a position such as this, the trader will benefit if the market moves up OR down and will look to monetise the realised volatility of the market via actively hedging their straddles (i.e. trading the option ‘gamma’) and betting that the profit generated from that is greater than the option premium loss from the time decay of holding the long option positions (option ‘theta’). The high volatility of volatility (both realised and implied), as well as the irrationality and periodically extreme price movements of the cryptocurrency market means that these types of strategies (as well as other technical absolute and relative value strategies) can be very lucrative for those, such as our new fund, DAF Greeks, who are poised and able to capture them.
Alternatively, to illustrate how a directional trade can become non-directional we can take a long call position as described above, and instead of letting spot move over the life of the option and hopefully settle in-the-money at expiry, the trader will actively ‘delta-hedge’ the position to keep the directional exposure close to neutral and take advantage of market movement between entering the position and the expiry of the option. Once again, in practice to effectively do this is far more complex than detailed above.
Conclusion
We hope this article has given readers a broad overview of the digital asset options market as it currently stands, why we believe it is poised for further growth and some basic information on options trading itself.
By Joshua Green, Head of Trading, Digital Asset Capital Management @JoshuaGreenDACM
Disclaimer: Digital Asset Capital Management is the Investment Manager of the DAF Greeks Fund Inc. a discretionary buy-side derivatives and options focused hedge fund that applies institutional level options strategies to harvest alpha from cryptocurrency derivatives markets.
