Introducing the Volatility Protocol volatility token
Tl;dr: This article will outline how to create a decentralized, tradable volatility product. In later articles, we will introduce the more complex and math-heavy concepts of volatility. At the end of this, you will understand what volatility is in DeFi and why you would trade a volatility token.
The series will pave the way for the Volatility Protocol’s volatility products being built on UMA. We intend to create both approachable and educational content to understand the value behind using the products to hedge risks or generate profits.
What is Volatility?
Volatility is a statistical measure of the variation in price an asset experience over a given period of time. Specifically, volatility is the rate and amount of change an asset moves away from its mean price in a given time period. Trading volatility is a fundamental part of financial markets as it has become a ubiquitous way to insure one’s portfolio (e.g. a hedging instrument). Measures of volatility are also essential as they are intrinsically tied to options and futures pricing.
As an example, let’s pair ETH with the stable coin USDC. ETH’s volatility to its underlying price would be directly related to how much its price changed in a discrete-time period. For example, if the price movement was minimal and the time length was very long, the volatility would be low. Vice versa, if the price movement was significant and the time length was concise, the volatility would be high.
The simple example above doesn’t truly capture how volatility is measured but instead describes the underlying principles that different methodologies used for calculating volatility. In practice, various models (e.g. GARCH) and model-free methods (e.g. Cboe VIX) are used to calculate volatility.
There are two main volatility measures, historical volatility (HV), sometimes called realized volatility, and implied volatility (IV). Realized volatility is backwards-looking and is typically calculated as the standard deviation of a price over a given time period. Implied volatility is a forward-looking measure of expected volatility and is generally calculated through a predictive model or a model-free approach (e.g. VIX). We’ll go into more detail about this model-free methodology in a later article. For now, it’s easiest to think of implied volatility as a prediction of future volatility based on observed market sentiment.
Volatility instruments are essential for traders of various strategies to take advantage of price fluctuations and hedge against the risk of severe price movements. Often, volatility measures go hand-in-hand with risk. In other words, an asset with a more volatile price action is often considered riskier.
Volatility in CeFi
Trading volatility is currently possible in the crypto world. Centralized derivatives platforms like Deribit and FTX offer black-box volatility products. The goal of Volatility Protocol is to create a suite of fully decentralized volatility products that do not rely on centralized options markets and are independently reproducible.
Creating a volatility token
Using UMA’s priceless financial contracts and infrastructure, we can easily create a synthetic that tracks the volatility. Very simply, if you mint a long volatility token and volatility goes up, the token increases in value. Whereas if volatility goes down, the token decreases in value. The price feed for the synthetic can be any predefined volatility method.
For Volatility Protocol’s volETH and ivolETH price feeds, we use a model-free, near real-time measure of volatility. You can learn more by looking at the methodology paper or in a later part of this series, where you can see an overview.
Looking forward
As the number of DeFi products start to grow, it’s natural to assume the proliferation of traditional finance instruments will continue to make their way to DeFi. VIX products are a step towards an ever-growing repertoire of instruments to transfer risk and make a profit.
The following articles will break down the more complex mechanics of implied volatility by walking through the volETH and ivolETH tokens, how they work, and how a trader might use them in various strategies. We will also expand the concept of why inverse tokens are so important to both volatility and synthetics in DeFi. Specifically, we’ll demonstrate how inverse tokens solve liquidity providers' problems and arbitrageurs when minting and trading.
Keep an eye out for upcoming news about the next article and news around the product launch.
This story is a collaboration between UMA and Volatility Protocol. This was authored by Chandler, ccashh and Wade Kimbrough.
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