November 24, 2022

Desk Commentary - Calling All Options

In this week’s Desk Commentary, we are more expansive by including some data scientific approaches we have taken in linear products.

This dovetails nicely with equally actionable ideas on Deribit products.

  • In a market bereft of conviction with a decidedly short half-life for trust, it’s fitting to ask not only where is accessible optionality but furthermore whether one’s tools are correctly calibrated to assess the value of a prospective option.
  • Philosophically, the value of options can, as one simplifying heuristic, be expressed as the returns of dynamically hedging the instrument with the underlying asset according to a set of distributional assumptions which also inform risk neutral probabilistic assessments of the future moniness of the option.
  • What isn’t contained in the theory is the requirement that the venue for the instrument be one in which actors have adequate trust to tie up capital to make the sorts of aforementioned wagers and in which, moreover, there is sufficient general interest that liquidity to enter and exit options positions remains adequate. Beyond that, an ability to fulfill the promise of a dynamically hedged strategy requires well-functioning marketplaces to go long and short the underlying.
  • Within the crypto space, a number of those assumptions about persistence or trustworthiness of venues are being tested, and distortions in delta1 pricing and liquidity are pervasive as funding grows dysfunctional. Spot-futures basis on major exchanges in bitcoin has plunged into negative territory, for instance, as OTC coin borrows have dried up, with absolute annualized premiums pushing -25 to -30% on some venues for dated futures.
  • In addition, the same constraints that dictate venue-based liquidity preference for delta1 hedges have also led to disparities in option markets, where an apparent dearth of fungibility of ‘vol’ amongst OTC, $ settled, and coin settled contracts, principally owing to systemic risk concerns, has been made manifest. Given the degree of prevailing uncertainty, it may seem strange, for instance, to see longer dated IVs closer to the lower quartiles of their distributions (31March23 ETH 25 delta calls at 75% implied vol come to mind for instance). Yet, with capital scarce and venue confidence periodically under fire, it remains to be seen who has and will deploy balance sheet to scoop what may turn out to be value priced optionality. In that context, the optical payout ratios for dated call spreads (such as March 1600/2000 at roughly 4% of ETH) do not look unreasonable – if there is willing dry powder to be spent on them.
  • Yet non linear products are not the only instrument to offer a convex return profile. Particularly after the sharp selloff (and disparate performance) across the crypto complex, it has historically tended to be the case that some assets make better ‘recovery’ longs than others, particularly if one considers pairing longs against shorts. In that context, it would be remiss not cast a glance on the vertiginous moves in Litecoin (+27%) and to a lesser extent Ethereum Classic (+13%) in today’s modest bounce. While the drivers for the day’s idiosyncratic outperformance are worth a twitter feed (and then some), it is a worthwhile exercise to assess whether certain tokens such as these offer exposure akin to a call option on up-vol off a deeply discounted industry market cap. ETC’s beta to ETH has, in particular, on a metric of 5 day rolling ols estimator, demonstrated a propensity to surge from 1 to as much as 4; on longer time window, ETC outperformance of ETH has ranged from 1%-5% on a “rally” (defined for the purposes of this discussion as the top ~35%’tile of ETH returns), with an annualized information ratio > 8.
  • The upshot of a casual assessment seems to suggest, not surprisingly, that with the chaos strewn through digital asset markets, there may be overlooked (or potentially underpriced) optionality to be exploited for sufficiently well capitalized and appropriately calibrated balance sheets.

Written By

Gordan Grant

Managing Director, Trading and Sales


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