At the same time that volatility and short-term implied volatility have been sucked out of the market, longer dated options (six months or so until expiration) are still pricing closer to their historical average volatility in the 70% range. This steepness in implied volatility term structure suggests one of two things: Investors expect that this period of low volatility will be transitory and that a catalyst in the next couple of months will once again rock markets, or perhaps sellers of options are just not willing to make a longer-term bet, and as such, are not providing any supply in these longer-term options. The result is a steepness in term structure that could present an opportunity for the volatility-savvy trader.
Implied volatility is an interesting asset to trade. Most individual investors who use options as part of their investment strategy do so for the purpose of speculation or protection. They might even employ income generation strategies by selling options against their holdings. They tend to be focused on prices: What level do they think this asset can get to before expiration? Where would they be willing to sell it or buy it? While the nuances of volatility and options pricing may not be obvious to everyone, every trade that a trader makes is implicitly taking a stand on implied volatility.
On the other side of the individual investors’ trades are option market makers. These players think of almost nothing but implied volatility. The goal of a market maker is to keep their net position as flat as possible while collecting a bid/ask spread on each trade. The likelihood of order flow being balanced on every single option strike and expiry is essentially zero, so they use implied volatility curves and term structure to relate option prices to each other, keeping their risks balanced even if their position becomes a hodgepodge of long and short calls and puts at all different strikes and expirations. Option market-makers prefer to have all their risks balanced out, but when customer order flow is concentrated in one direction, sometimes that is simply not possible.
The result of this unbalanced order flow, with investors happily selling short-dated options while being skittish to sell longer dated options, has led to extreme steepness in the implied volatility term structure in Bitcoin (BTC) options. As of this writing, according to data analytics service Skew, the implication in options prices (as illustrated by forward implied volatility, which is the calculated volatility between two specific expiries) shows the expectation that volatility will realize 30% in the next week, the last week of July will see volatility of 50%, the month of August will see 60%, and the month of September will see 70%.
Perhaps the market is right and has great insight about when the current low volatility environment will end. But more likely, order flow is at such a disbalance between expiries that market-makers have twisted the term structure to levels that present some positive expectancy opportunities.
If traders wanted to express the opinion that the current cycle of low volatility reinforced by continued short-dated option selling will continue, they would do well to sell both calls and puts on various strikes with expiration dates in six to eight weeks, just after the inflection point where implied volatilities really start to drop off.
If the current environment continues, they will likely see gains not just from collecting decay on the option premium, but also from implied volatilities “rolling down” the term structure surface. If they wanted to, or needed to, for margin purposes, they could hedge some of the risk of an unexpected event by buying a few options in much longer dated expiries and a few contracts in cheap, short-dated expiries as well.
No one can predict exactly when the next high-volatility market event will come, but it’s likely not tomorrow. It is more likely to happen within the next month, and even more likely than that — within the next two months.
It is very reasonable for volatility term structure to be upward sloping, but the current steepness in that slope implies a specific time frame for the reemergence of increased volatility coming in early August. It’s entirely likely that this implication is priced into the Bitcoin options market not because it’s the actual forecast, but because there are plenty of investors willing to sell two-week options, while there are few willing to sell one-month and two-month options.
If a trader has the appetite for this risk and believes that there is no specific reason that realized volatility should double within the next several weeks, they could theoretically get paid a hefty premium for selling those options.
This is part two of a two-part series on Bitcoin volatility — read part one on the rise and fall of BTC volatility here.
This article does not contain investment advice or recommendations. Every investment and trading move involves risk, readers their own research when making a decision.
The views, thoughts and opinions expressed here are the authors’ alone and do not necessarily reflect or represent the views and opinions of Cryptox.
This article was co-authored by Chad Steinglass and Kristin Boggiano.
Chad Steinglass is the head of trading at CrossTower, an exchange operator. He has over 15 years of experience trading equity, index and credit derivatives. He was an options market-maker at Susquehanna and Morgan Stanley and the head trader for a division of Guggenheim. He was also a portfolio manager of capital structure arbitrage at Jefferies. He is an expert in market dynamics, market microstructure and automated market-making and trading systems.
Kristin Boggiano is president and co-founder at CrossTower, an exchange operator. Kristin is a structured products, regulatory and digital asset expert who brings over 20 years of experience as a trading and regulatory lawyer and over nine years in digital asset trading and regulation. Prior to founding CrossTower, Boggiano was a chief legal officer of AlphaPoint, managing director of an algorithmic trading platform at Guggenheim, and special counsel at Schulte Roth, where she founded the structured products and derivatives division and led the regulatory group for Dodd Frank. Kristin is also the founder of Digital Asset Legal Alliance and Women in Derivatives. She earned her law degree and MBA from Northeastern University and her B.A. from Sarah Lawrence College.
