Cryptocurrency traders always use the options market to bet that the prices of digital assets like bitcoin and ether will rise or fall.
A lesser known use for options trading is simply to bet on whether price fluctuations or volatility will increase or decrease. And, according to experts in the cryptocurrency market, the market is now ripe for this kind of bet.
“The implied volatility of a short-term Bitcoin option is trading below the realized volatility,” crypto derivatives data provider Genesis Volatility wrote in its weekly newsletter published Sunday. “Ether implied volatility is trading at a huge discount to realized volatility.”
When implied volatility is trading below historical volatility, it is a sign that the market is underestimating the prospects for future price turbulence versus recent price turbulence. Consequently, implied volatility can rise, converge with historical volatility, and cross it, pushing up option prices and bringing profit to buyers.
“Buying options (call / put) in this environment is extremely interesting,” said Genesis Volatility.
Traders buy options when volatility is relatively cheap and sell when it is high. Thus, trading volatility is quite simple in nature: it is based on an old investment saying about buying low and selling high. This is analogous to buying an asset in the spot market when it is perceived to be undervalued and selling when it seems overvalued.
Implied volatility refers to the market’s expectation of price turbulence over a period of time, while historical or realized volatility is volatility that has already played out.
Volatility has a positive effect on option prices. Options are hedging instruments that give the buyer the right, but not the obligation, to buy the underlying asset at a predetermined price on or before a specified date. A call option gives the right to buy, and a put option gives the right to sell.
According to data provided by Genesis Volatility, Ether’s 10-day implied volatility is 87%, well below the 97% 10-day realized volatility.
Bitcoin’s 10-day implied volatility has traded well below its 10-day historical volatility for nearly two weeks; However, over the past few days, the gap has narrowed somewhat. At time of publication, 10-day implied volatility was 69% and realized or historical volatility was 72%.
Some traders take advantage of these situations by buying non-directional or market neutral strategies such as straddles and chokes, which involve buying an equal number of calls and puts and taking advantage of the surge in volatility.
A long straddle is set by buying a call and a put option with the same expiration and strike price (usually closest to the price of the underlying asset in the spot market).
For example, when Ether is currently trading at around $ 3,170, a trader expecting a significant spike in implied volatility may choke on the May 28 call and put options at a $ 3,200 strike price.
Long choke involves buying calls and puts with the same expiration date at strikes equidistant from the spot price. Buying an ether call at $ 3,300 and a put option at $ 3,100 will create a long hit.
“Traders use strategies such as long straddles and chokes that involve buying both calls and puts when volatility is expected to rise,” said Luuk Stryers, founder and chief commercial officer of Deribit, the dominant crypto options exchange. “This is more likely at this point because implied volatility is lower than realized volatility.”
In these strategies, the risk is predetermined, with the maximum loss limited by the amount of the premium (option price) paid when buying a call and a put. Straddle and choke fail when the expected spike in implied volatility remains elusive before expiration. In such cases, the options steadily lose value as they approach expiration and become nil on the day of settlement.
However, the returns can be significant as, in theory, the underlying asset can rise indefinitely, pushing implied volatility to the moon and generating colossal profits on a long strategy call position. Likewise, the asset could drop to zero, which would generate significant profits on a long position in the put strategy.
As with other options strategies, traders consider many factors, such as time remaining to expiration and the flow of macro news / events, as well as implied volatility and historical volatility, before taking long straddles / chokes.
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