A quick guide to extreme bitcoin derivatives, for the bullish and the squeamish alike
It’s natural that the current bitcoin bull-run would spawn new and more extreme option contracts. Last month, the Deribit exchange offered a BTC-24SEP21 Call, giving investors the option to buy bitcoin at $100,000 in September. (Deribit is also offering an option with a $200K strike in Dec, but let’s ignore that for now, for the sake of our blood pressure.)
At the time of writing, the $100K option contract costs “only” $2,700, which means there’s a huge reward-to-risk ratio. If, six months from now, bitcoin surged to the strike price of $100K, then a $2,700 option contract could produce a profit of $20–22K. Not bad, right? Especially when we hear serious commentators arguing that BTC could go as high as $400K.
What if the $100K price is reached just three months from now, rather than six? Depending on volatility (remember: the higher the volatility, the greater the potential return), then we could potentially get $30–32K in profit. If you invested in 1BTC worth of these options, you’d be looking at a profit as high as $350K — as shown in the chart below.
On the flip-side, if Bitcoin creeps up or down with low volatility, the way it was mostly doing in the latter part of 2020, or indeed if it fails to surge exactly how and when we need it to, then our investment could be obliterated in less time than it takes to even log into our exchange account.
Why do this to yourself?
Why would we consider such a contract? Especially this week, when the British regulator has reminded us all of the risks of crypto derivatives by banning them for retail investors?
Well, for a start, the fund where I work — BR Capital — is not an amateur investor. We have a long-term interest in the progress of the crypto economy and we see derivatives, when done properly, as a key part of that progress.
We have some more specific reasons too:
- As a crypto fund, we can use derivatives to hedge positions (e.g. to compensate for the potential opportunity cost of reducing our BTC holdings to invest elsewhere);
- We are constantly exploring new crypto products and markets in which to deploy our successful HFT and arbitrage strategies;
- We know that when any asset enters new, unexplored price territory, as BTC recently did, then volatility is likely to increase (as it has done by around 40 percent between mid-December and now). Theoretically, at least, option contracts are in turn more likely to be lucrative as a result of this volatility. (Although, let’s be clear: we are not giving investment advice here).
How to evaluate such an option?
At BR Capital, if we categorise an investment as “experimental,” it will be subject to even more debate and scrutiny than a regular investment with more familiar mechanics.
We would not buy a $100K BTC option contract without first agreeing some principles for understanding BTC price movements. We have a number of such principles at hand, such as the MVRV indicator that we discussed in our latest market report. The MVRV indicator is widely being interpreted right now as showing that BTC has a lot further to climb — perhaps not to $400K, but higher than $100K.
Secondly, we constantly model different scenarios, with a big focus on volatility (for which there’s currently little in the way of crypto-specific modelling tools), and then we track price movements against those models to check our understanding. Arguably, this is where we learn the most and therefore get the most value from our investment, even if it turns out to be financially worthless in the end.
This brings us the final and most important method for evaluating these kinds of contracts: stop evaluating the contract for a moment and instead evaluate how much money you’re happy to lose in return for education and the other indirect benefits of active participation (such as buying the right to engage in meaningful debates with other active investors).
Where next for crypto derivatives?
We’re happy with the bullish position we’ve taken on BTC over the years, and we’re happy that derivatives are continuing to emerge that allow us to profit from our optimism beyond just HODL-ing.
However, we do not want to be limited solely to derivatives offered by centralised exchanges. For current options trading, we are comfortable with Deribit and with market risk, but we see that counterparty risk could become more of a concern as a greater number of little-known and little-regulated crypto exchanges start to offer derivatives.
Over time, as more like-minded professional investors come into this market, demand will increase for decentralized derivatives products that are secured by smart contracts and collective liquidity pools, boosting startups like Hegic, Nexus Mutual and Opyn.
As they mature, DeFi derivatives will represent an important milestone, possibly exerting a stabilising influence on the underlying assets and thus helping to solve some of the complaints about crypto derivatives that are being raised by regulators. Please stay tuned — we hope to cover more about DeFi derivatives very soon!
