Directional traders betting on bullish or bearish price trends once dominated the crypto market. Since last year, another type, known as volatility traders, has emerged. These traders bet on a rise or drop in implied or expected price volatility over a specific period.
These entities are increasingly employing strategies to profit from market information that is public; notably, the weekly automated options strategies that are auctioned by decentralized option vaults (DOVs). Every Friday at 11:00 Coordinated Universal Time (7 a.m. ET), the vaults allow anyone willing to deposit their coins there to earn double-digit annualized returns.
These vaults sell higher strike, or out-of-the-money (OTM) calls, and lower strike OTM puts, driving implied volatility lower each Friday. Sophisticated traders are virtually front-running the drop in implied volatility. The strategy is similar to running a typical short position in the spot or futures market to benefit from an expected decline in prices.
“DOV auctions drive down volatility and [options] premium prices,” Two Prime’s DeFi options explainer published on April 8 said. “Since these auction times and mechanics are public information, volatility sellers across short-term tenors, like Two Prime, can profit from short-selling [volatility] in front of these auctions and buying during and shortly after the auction event.”
Options are hedging instruments that give the purchaser the right but not the obligation to buy or sell an underlying asset at a predetermined price on or before a specific date. A call option gives the right to buy, while a put conveys the right to sell. Demand for hedges is high when uncertainty about future price action is high. Therefore, implied volatility and options price rises with increased demand, while options selling lowers both.
Decentralized option vaults have simplified the otherwise complicated options trading for retail investors. All users need to do is deposit their coins in the vaults, which take care of complexities like selecting the appropriate strike price for selling OTM calls and puts. The premium collected from selling options represents the yield from the trade and is distributed among users in proportion to their deposits.
DOVs have seen explosive growth in a year to become a significant part of the decentralized finance (DeFi) options ecosystem, now worth nearly $1 billion as per total value locked, data source DefiLlama shows. According to Two Prime, the DOV-powered weekly covered call and covered put strategies are two of the most popular trades and currently add over $100 million of notional exposure to the market, driving the implied volatility and options prices lower.
The chart above shows that on crypto options exchange Deribit’s ether implied volatility index (ETH DVOL) tends to drop in hours leading up to the weekly auctions held each Friday and rises following the conclusion of auctions.
“In 2022, the Deribit Implied Volatility Index, a measure of implied volatility on BTC and ETH options, has trended lower into the auctions period,” Two Prime said. “For 100% of occurrences 4 to 7 hours leading up to the auction, volatility has fallen as short open interest pushes [options] premiums lower.”
The pattern has created a window of opportunity for savvy traders to sell volatility via short call or put positions ahead of the auction and square off the trades at relatively cheap prices brought by the auctions-induced decline in the implied volatility.
“The strategy has been quite popular,” Robbie Liu, senior researcher at Babel Finance, said. “It was very profitable initially, but with time, more and more traders are doing this. So, profitability has been diminishing quickly.”
Vol selling is a risky business
Traders writing or selling options in a bid to profit from an impending drop in the implied volatility are exposed to sudden price swings.
Traders typically sell volatility (via short put or call) when the implied volatility is too high relative to its lifetime average and historical volatility. On the contrary, traders buy volatility (via long call or put) when the implied volatility is cheap compared to historical standards.
However, while implied volatility is moving away from the mean, there is no guarantee when it will do so, and there is no limit as to how high it can go. In other words, the implied volatility can stay elevated longer than volatility sellers can stay solvent.
Besides, a call option seller is obliged to sell the asset to the buyer if the latter decides to exercise the option to purchase at an agreed-upon price.
So, in theory, the seller is exposed to unlimited losses and the buyer can make an unlimited profit as the market can virtually rally to infinity. Similarly, a put seller’s account can be wiped out in a falling market.
“Selling option premium creates convex risk/reward profiles that often surpass simple long/short futures or spot trading strategies. Back-tested versions of these strategies have performed well in some environments but have also experienced significant drawdowns when markets move outside the expected range,” Two Prime noted.
Appeared first on Coindesk