Surviving Crypto Volatility With Derivatives Contracts

Volatility has been the dominant theme in financial markets lately. As uncertainty around COVID-19 and its impact on the economy deepens, markets have been swinging wildly. We’ve seen the S&P 500 falling off a cliff as well as risk assets across the board taking a beating. Cryptocurrency markets have been no different and have exhibited extreme volatility. Amid the pessimism, Bitcoin (BTC) broke below the $4,000 mark on Black Thursday and fell nearly 50% from recent highs. 

It’s been over a month since the crash, and though we have seen prices bouncing back sharply, the sentiment has not improved. There is still a fair amount of fear among traders, and they continue to stay hawkish. Such sharp moves hurt market confidence, and it will take some time before traders get comfortable carrying overnight risk again.

It is hard to say how long it will take for the markets to recover and for the true impact of the current crisis to be visible. Some estimates suggest that it will take as long as 12–18 months for the world economy and markets to fully overcome this shock. Given the backdrop, it’s fair to say that markets should remain choppy for some time and that the volatility is here to stay.

Volatile markets increase directional risk

Extreme volatility in the markets spells trouble for traders caught on the wrong side of price swings. On March 12, the price of Bitcoin dropped by over 40% and subsequently recovered 16% the next day. Over $750 million worth of positions went into liquidation amid these swings. 

Bitcoin volatility spiked to 250% per annum in March, and though it has cooled down to about 70%, it still remains quite rich. Carrying directional trades in such volatile market conditions is very risky. In fact, the higher the volatility, the higher the directional risk for traders. If traders don’t maintain enough margin in their positions, there is a chance of getting caught on a price whipsaw and getting liquidated. Violent price swings have been a regular feature since Black Thursday. This has made directional trading difficult not only for new traders but also for veterans. 

Isolating directional risk from volatility risk 

In calm market conditions, traders look to profit by catching the momentum of the market direction. If they predict the market direction correctly, they register a profit. Similarly, if the market moves against them, there will be losses. The amount by which a trader’s portfolio is going to get impacted per unit movement in price is called “delta” — a measure of directional risk. There is another risk to a trader’s portfolio, something that most traders tend to ignore during calm market conditions: the risk of price swinging up and down while it drifts in a particular direction. This risk to a trader’s portfolio is called “vega” and measures the risk against change in volatility.

Just as traders use futures contracts to position themselves for directional risk, options are useful for protecting against rising or falling market volatility. Traders can also use options to remove directional risk from their portfolios, partially or completely, and bet on market volatility alone. 

Some exchanges are at the forefront of innovation here and are offering products that allow traders to trade the volatility risk without taking any directional risk. Hence, should a trader believe that the market is going to stay volatile, they can buy volatility without exposing themselves to the effects of which direction the market moves in.

Growth in crypto options segment

As crypto derivatives markets mature, we are seeing more and more traders participate in options markets and trading volatility. In traditional markets such as equities, the volumes on options contracts can be multifold of those on futures contracts. Though crypto options markets have existed for a few years now, the volumes have been slow to pick up. 

Most crypto traders find options trading difficult to understand and intimidating. There is a need to package options in a way so that traders can easily understand the payoff profile without diving into the nitty-gritty. This would help reduce the friction and increase the demand for crypto options trading. A MOVE contract is one such product. Herein, a trader holds a straddle: a multilegged options position that will benefit from higher market volatility irrespective of market direction. 

The straddle strategy, simplified

One of the ways to own volatility is to buy a straddle. A straddle is nothing but a call and a put option combined together. Hence, one can create a long straddle position by buying a call option and a put option that have the same strike price and maturity. If the market rises, the call option becomes profitable; should the market fall, the put option starts to payoff. Building a straddle position by oneself can be complex for traders. Not only do they need to find liquidity in both the call and put options, but they must also execute both the legs of the trade simultaneously. 

MOVE contracts are nothing but a packaged straddle position. Thus, when a trader is buying a MOVE contract, they are essentially buying a call and a put option with the same strike and in equal amount. 

The crypto equivalent of trading the VIX

Cboe has an index called the Volatility Index, or VIX, which is also known as the fear index. The reason the VIX is called a fear index is because its value rises when market uncertainty or fear is high and falls when the market is calm. Investors can’t directly invest in the VIX, but they can bet on the VIX going up or down by trading futures on the VIX or by purchasing VIX-related products such as VIX futures exchange-traded funds. In cryptocurrency markets, trading MOVE contracts is the equivalent of trading VIX products, as it gives investors pure exposure to the volatility of crypto.

Removing settlement currency risk

Another important aspect of any derivatives product is the settlement currency — i.e., the currency in which the final profit or loss is realized. The default settlement currency for most crypto derivatives products is Bitcoin. This is understandable, given that when the crypto derivatives ecosystem was starting, stablecoins were still not commonplace. Thus, products that allowed payoff in Bitcoin or other cryptos were innovated. This was also partly driven by customer demand, as traders focused on increasing their count of Bitcoin. Things have changed a lot in the last 12 months, and we’ve seen a strong demand for stablecoin settlement in the crypto derivatives segment. 

Gold futures, stablecoin futures and the growing demand for stable assets

Other ways to combat a volatile market include switching to low-risk assets such as gold.  Futures contracts on gold-backed coins have provided crypto traders with a way to protect their portfolio value in times of widespread uncertainty. These derivatives have also opened a new sector of trading that allows crypto traders access to physical gold. They have been in high demand on many derivatives exchanges because of the recent gold price spike in the backdrop of the coronavirus scare and global markets sell-off.

Futures contracts on stablecoins are also getting popular, as there are arbitrage opportunities for traders to earn profit in a stable token’s value while taking minimal risk. Overall, the industry has seen a surging demand for a stable digital currency amid fears of an economic recession and will continue to rely on stablecoins as a safe haven.

Final thoughts

Derivatives provide a way for traders to hedge in times of high market uncertainty, isolate and protect against different kinds of risks, and aid in true price discovery. In the long run, a healthy derivatives market helps to reduce the long-term volatility of an asset class.

The crypto derivatives segment has seen huge growth in the last two years, but we’ve only scratched the surface as of yet. For mature asset classes, derivatives markets are four to five times the size of spot markets. Currently, Bitcoin perpetual swaps make for the lion’s share of the crypto derivatives segment. As crypto derivatives markets grow, we will see increased demand to trade futures on other coins beyond Bitcoin and for options, as they provide a way for traders to manage volatility risk.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, you should conduct your own research when making a decision.