Profiting From Fear And Greed
(Any views expressed below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)
TL;DR
Volatility is the result of ongoing interplay between fear and greed. It goes up when financial markets are uncertain and goes down during periods of consolidation.
Deribit’s Volatility Index (DVOL) futures provide an easy way to trade volatility in cryptocurrency markets and profit regardless of the price direction.
Markets are driven by two emotions: Fear and Greed. When prices soar, people become greedy, driving them to pursue profits tirelessly and take unnecessary risks. On the flip side, during extended market downturns, fear seizes investors, prompting them to sell in order to protect themselves from further loss. This cascade of selling perpetuates a self-fulfilling prophecy, pushing prices even lower.
Fear and greed intertwine, shaping the very fabric of market movements, and understanding their impact is crucial for navigating this dynamic and unpredictable environment.
Volatility, the pace at which prices shift, serves as a measure of uncertainty, risk, and the potential for significant price fluctuations in the market within a given timeframe. Higher volatility signifies greater price instability, while lower volatility implies more steady and foreseeable price movements.
In the stock market, the CBOE Volatility Index or better known as the VIX is the definitive measure of market volatility. It is constructed from the prices of out-of-the-money (OTM) put and call options on the S&P 500. The puts capture the prevailing fear, expecting a possible price decline, while the calls reflect the strong desire for profits, embodying greed. The VIX emerges as the resounding “fear gauge,” channeling investors’ collective projections of volatility in the near term.
If you’re unfamiliar with trading options, a PUT option (bearish) empowers you to sell an asset at a predetermined price and date, while a CALL option (bullish) grants you the privilege to purchase an asset at a predetermined price and date.
Click here to learn about the basics of options and how they work.
The Deribit Volatility Index (DVOL)
Deribit, the most liquid cryptocurrency options exchange, first introduced the Deribit Volatility Index (DVOL) for Bitcoin and Ethereum in March 2021. The DVOL expresses the 30-day forward-looking expected volatility or implied volatility by its OTM calls and puts.
Interpreting DVOL
DVOL is expressed as an annualized figure, to get the expected daily price move we can divide the DVOL value by 19 (the square root of 365).
For example, if Bitcoin is currently trading at $27,000 and the Bitcoin DVOL value is 45, the market expects the price to move approximately 2.37% in either direction.
Volatility is neither inherently positive nor negative, however, large moves in the DVOL often coincide with rapid decreases in price.
The image above shows the Bitcoin DVOL vs its price over the last year. The highlighted areas signify the collapse of Three Arrows Capital and FTX, events where volatility peaked and prices experienced a large move to the downside. As the price rapidly fell, the DVOL rapidly increased (fear rises), and as the price slowly settled, the DVOL gradually decreased (fear dissipates).
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Trading Volatility
Suppose you anticipate a significant price change in Bitcoin due to news but are unsure of the direction. In that case, longing volatility lets you capitalize on the expected increase in volatility regardless of the price direction.
Trading Volatility with Options
Options can be used to trade volatility by utilizing a strategy called a straddle.
A long straddle involves purchasing both a call and put option at the same strike price and expiration date, aiming to profit from significant price movements in either direction, typically associated with high volatility. On the other hand, a short straddle entails selling both a call and put option at the same strike price and expiration date, with the potential for profits when the price settles, typically in periods of low volatility.
Suppose you decide to open a 1x BTC-23JUN30–27000 long straddle position by purchasing the BTC-23JUN30–27000-C for $1,135 and the BTC-23JUN30–27000-P for $1,125.
The cost for opening the position is as follows:
Price of the call + Price of the put = Total Cost
$1,135 + $1,125 = $2260
Since a straddle consists of buying a put and call option, it has two break-even points. We can calculate the upper and lower break-even points with the following:
Call Strike Price + Total Cost = Upper Breakeven Price
$27,000 + $2260 = $29,260
Put Strike Price — Cost = Lower Breakeven Price
$27,000 — $2260 = $24,740
Here’s what our pay-off chart would look like:
In order for our position to profit (the area highlighted in green), the price has to move significantly above $29,260 or below $24,740 by June 30th. If the price expires between our break-even points (red area), our position will be worthless.
Straddles can be more complex trading strategies, and may not be suitable for beginners. Its profitability is heavily dependent on the path of the underlying price during the course of the trade. If the price remains relatively stable and doesn’t experience significant fluctuations, both the call and put options may decline in value due to the decay of time value (theta decay), resulting in a potential loss for the straddle strategy.
Trading Volatility with DVOL Futures
Deribit has recently launched monthly BTC DVOL futures contracts; the first tradeable instrument that allows us to speculate on the pure market volatility of Bitcoin.
These are cash-settled in USDC where each 1 BTCDVOL level is equivalent to 1 USDC. For example, if the BTCDVOL June 28 future is trading at 49.2, then 1 BTCDVOL contract = 49.20 USDC.
Trading BTCDVOL is just like trading any other futures instrument or spot asset. If you’ve traded before, then the interface shown above should look familiar.
Similar to a long straddle, buying or opening a long position on the DVOL future allows us to profit from significant price changes in Bitcoin (increase in volatility), regardless of the direction of the price movement. Conversely, selling the DVOL future (similar to a short straddle) allows us to profit when the price trades sideways (decrease in volatility).
DVOL Futures vs Option Straddles
DVOL futures provide a direct and straightforward way to gain exposure to volatility. They have a single expiration date, which simplifies the decision-making process. On the other hand, option straddles involve the simultaneous purchase of call and put options, requiring careful evaluation of specific strike prices and expiration dates, thereby introducing complexity to the overall strategy. Moreover, option straddles expose traders to the intricacies of Option Greeks such as time decay (theta), which can swiftly impact the profitability of the position during the trade.
While both DVOL futures and option straddles have their own complexities, retail traders may find DVOL futures comparatively easier to understand and trade due to their simpler structure and more streamlined trading process.
Conclusion
Fear and greed are two powerful emotions that can greatly influence market volatility. They represent the extreme ends of the emotional spectrum that drive investors’ decisions in financial markets. Their interplay creates a volatile market environment of rapid and significant price shifts, offering both risks and opportunities.
Deribit’s DVOL futures provide an easy way to speculate on volatility in cryptocurrency markets. These instruments eliminate the need for in-depth options trading knowledge that was previously required with option straddles. Traders can now effortlessly gain direct exposure to pure crypto volatility, fostering its growth as a tradable asset class, parallel to the VIX in traditional financial markets.
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