An ETH holder’s guide to ‘volatility skew’ and how it can hedge you against seller’s remorse
Markets rarely price risk in a completely logical or balanced way. As a careful crypto investor, you can sometimes use this to your advantage through a principle called “volatility skew”.
This principle is especially relevant now if you’re an ETH holder enjoying the new all-time-high prices and thinking about taking your profit — and then worrying that you might regret it later if ETH doubles again. (Which it may well do, since ETH underpins a large portion of the burgeoning DeFi space.)
Note: This article is educational and should not be taken as investment advice.
Hedging through options
An interesting strategy is to pay a relatively small price to protect the value of your current ETH holding, so you can be sure of this value without immediately cashing your ETH out to some other currency. At the same time, you will still being able to benefit from further ETH price growth by a partial but still useful amount (e.g., 50–80% of the growth you would have had if you’d simply held onto your ETH with no downside protection).
This is facilitated by ETH options, accessible on derivatives markets like Deribit , Binance, Delta Exchange and others. (We’ve used Deribit products in the examples below, but you should scan for the best available options at the time.)
What is volatility skew?
Volatility skew is what happens when options markets price upside and downside risks differently. In traditional options markets (e.g., options on company stocks), major market crashes led to greater demand (and hence higher prices) for options that offered downside protection, compared to speculative options that only paid out if an asset price soared. But in crypto, and particularly with ETH, it is the other way around: there is so much positive energy and speculation in the market, that options that protect your downside risk are the ones which are cheaper. This is a huge advantage if you’re a cautious person!
Let’s look at two alternative strategies, one for the mid-term and one for the long-term.
Three-month strategy
With this strategy, you would buy a put option (i.e., an option to sell) at a price that is as close as possible to the current price. At the time of writing, the ETH price is around $3,300 and there is a put option available with a strike of $3,000 at the end of July. So, once we have bought this option, we have secured at least $3,000 of value from our ETH until this time. (The cost of this option is $350 — but don’t worry, we’ll get it back in the next step.)
Secondly, let’s sell the option for someone else to buy our ETH at $5,000 on the same date. Although this transaction would only make sense to a buyer if there’s a big jump in price, the positivity in the market means that the price of this option is also just $350, so we get our initial money straight back.
Now, if ETH halves in value, we’ll use our put option to avoid any loss greater than 10 percent (i.e., the gap between the current price of $3,300 and the strike price of $3,000). But if ETH doubles in value to $6,600, such that someone makes use of that option to buy our holding at $5,000, we still managed to get around half of the upside.
Longer term cover
The same mechanism can be used for longer term cover. The Deribit exchange is offering an ETH put option for March 25th, 2022 (11 months from now) with a strike price of $3,000. It costs $770, but you can get the money back by selling a call option with a $6,000 strike for the same price.
This means that, in almost a year’s time, if your downside risk is also most totally hedged, while you can still take up to 80 percent of the upside if ETH doubles in value during this period.
Risk vs reward
Thanks to this ability to buy a put option and sell a call option at the same time, we can be almost (almost) perfectly hedged. We’re looking at a cost of around $300, or 10 percent, but there’s a risk/reward ratio of 1:5 for the three-month option, or 1:8 for the longer term option. Not bad, right? And it’s all made possible by the positivity in the crypto market and it’s knock-on impact on volatility skew.
