Rising Prices Have Reawakened Option Markets

Since the start of the new year, a trending market has raised crypto prices (BTC +28%, ETH +32%) and reawakened interest in option markets.

These large moves have jolted implied volatility out of its doldrums, with BTC and ETH options rising +10-25% across all maturities. Not surprisingly, demand has been concentrated on upside call options. The next few months look promising for long volatility, with a choppy macro environment and important fundamental catalysts in crypto, namely the Shanghai hard fork in Ethereum scheduled for March. Add to the mix that the crypto market is once again at +$1 trillion just as regulatory scrutiny is reaching an all-time high, and 2023 could be a very eventful year.

In this report, we will discuss some strategies for exposure to Vega, Gamma and upside options. We will also explore the strange disconnect between realized volatility and large price movements thus far this year. Specifically, we investigate how mean-reverting or trending markets (like January 2023) affect option strategies differently depending on how they are delta hedged.

Term Structure - Volatility Snaps Back

• BTC and ETH Implied Volatility has jolted higher this week, gaining +10%-25%.
• The rise in volatility has been driven by spot prices breaking out of their narrow ranges to gain +28% (BTC) and +32% (ETH).

30-Day Option Skew - Upside Demand

• ATM volatility for 30-day options has risen almost 20%.
• Upside calls have risen a comparable amount to ATM options, while downside puts have been less affected by the rally in spot.
• BTC and ETH volatility are back to their long-term average range of 60%-100% volatility.

90-Day Option Skew - Puts vs Calls

• Relative to last week, 90-day options show a clear increase in demand for upside calls.
• Note that the lowest priced options have shifted from 110% strike last week to 95-100% strikes while spot prices have rallied 10-15%.
• This is a classic example of "Sticky Strike" volatility dynamics.

Realized Volatility - Mean-Reverting Market

• It possible for markets to display high volatility while ultimately returning to their starting price for the month or year (Mean-Reverting market).
• Similarly, it is possible for a market to have only small price movements per day, but for its direction to be generally the same (Trending market) such that the net price movement is large.
• Below is an example of a very volatile period for BTC (Oct 2017 - Apr 2019), during which BTC price had zero net change, despite ranging from $3,000 to $20,000.
• If a trader purchased an ATM straddle in October of 2017, expiring in June 2018 or April 2019, their profit/loss would depend entirely on if they delta hedged their position at several points along the way.

Realized Volatility - Trending Market

• Unlike the previous slide that showed an example of mean-reversion, the first two and a half weeks of this year have seen a trending market in BTC and ETH.
• Nearly all of the daily price changes have been positive.  The few days of negative price movement have all been smaller than -0.5%.
• Consistently positive daily changes have added up to large positive moves for BTC and ETH (28% and 32%), despite the daily changes being rather small (+2.1% average of positive days).
• This means that an options position will have experienced a large change in value over the last 17 days, despite realized volatility remaining very low.
• In a trending market, a long options trader will have greater profit when they do not hedge or only hedge infrequently.

Market Regimes - Hedging Frequency

• As discussed in the previous two slides, an option position will have different profit/loss characteristics depending on (a) how frequently it is delta hedged and (b) if the market regime is trending, mean-reverting or behaving randomly (zero autocorrelation).
• The table below shows the optimal hedging frequency for each market regime.
• Unfortunately, there is no such thing as a free lunch. The catch here is that no one knows for certain if a market will trend or mean-revert tomorrow.
• Therefore, these hedging heuristics, while useful, are only as good as the ability to understand market regimes.

Realized Volatility - BTC Daily vs Weekly

• Not all volatility is created equal. Another useful tool for understanding asset movements is to compare realized volatility with different sampling frequencies (hourly, daily, weekly, etc.).
• This slide and the next slide show rolling 30-day realized volatility, calculated by two different methods: sampling changes over 1-day periods (blue graph) and sampling 7-day price changes (orange).
• Note that while the methods have a similar average, there are periods where frequently hedged volatility (daily) and infrequently hedged (weekly) differ significantly.
• The regions circled in red are examples of trending behavior (weekly vol > daily vol). The regions in green are examples of mean-reverting periods (daily vol > weekly vol).

Realized Volatility - ETH Daily vs Weekly

• This graph shows the ETH volatility metrics with the same metrics (30-day rolling vol, daily and weekly sampling) as the previous slide for BTC.
• ETH experienced trending (red ovals) and mean-reversion (green ovals) in a similar fashion to BTC.
• Notice that the first 17 days of January (rightmost red oval) have actually seen a decrease in ETH 30-day (daily) volatility, declining from 47% to 39%, despite the large rally in ETH price.
• However, weekly sampled volatility shows a change that seems more reflective of option markets: Increase from 33% to 68%.

Vega & Gamma - ETH March Strangle

• ETH March 1400/1800 Strangle: $230 
• Pros: Great exposure to vol and Gamma for March Shanghai Fork and increasing crypto volatility
• Cons: Cost is approximately 14% of spot
• Implied Vol: 71% 
• Black-Scholes formula implies an 70% chance (Delta) of ETH expiring In-The-Money (either below $1,400 or above $1,800)

Bullish Options - BTC March Call Spread

• BTC March 25,000/35,000 Call Spread: $830  (about 3.9% of BTC)
• Pros: Excellent exposure to upside price movement for less than $1k
• Cons: No protection for downside
• Implied Vol: 60%-70%
• Black-Scholes formula implies an 33% chance (Delta) of BTC expiring above $25,000 

Global Market Capitalization $1 Trillion Once Again

• Today crypto prices reached a market capitalization of $1 trillion for the first time since the collapse of FTX.
• Although crypto is far from its high of $2.9 trillion in late 2021, the size of this market combined with the reshuffling of market leaders over the last year and increased regulatory scrutiny could lead to the emergence of new crypto institutions and leaders in 2023.

Technical Analysis - Relative Strength Index

• BTC has had a very strong start to the year, with a rise of +28%.
• While BTC was slightly overbought late last week (based on an RSI > 80), the RSI has moderated in the last two days without losing any of BTC's price gains.

Technical Analysis - ETH/BTC 

• BTC performance has been so strong over the past 7 days that it has eclipsed ETH gains in relative terms.
• ETH/BTC is now back inside of its 50-day and 200-day moving averages.
• While ETH has risen slightly more YTD than BTC (+32% vs +28%), BTC has outperformed when Beta is taken into consideration.