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This week markets continued chopping amidst the tight range-bound action, with Bitcoin retesting previous lows of $25,500 on Tuesday, and subsequently making a local high of $26,750 on Wednesday. In the days following, action in spot markets was minimal during the August 25th expiry of over $1.1b in open interest of Deribit BTC options and $890m in ETH options. Likely this was due to market makers rolling positions and rebalancing hedges earlier in the month in order to avoid liquidity issues or deal with heightened volatility during the days leading up to expiry.
Since last week the front end of the BTC volatility surface saw the largest changes, with 7 day at the money implied volatility dropping 8 points (the term front end refers to the collection of volatility smiles with closer dated expiries, usually 30 days or less). At the money implied vol for September 28th expiry dropped from 38 to 33 vol. Expiries of 60 days and greater did not see too many changes in terms of volatility only shifting down about 1 - 2 points. Ethereum volatility smiles behaved quite similarly with closer dated expiries shifting down 3 - 7 points, but longer dated expiries remaining virtually unchanged.
Since implied volatility reflects an essential component of option prices, we can interpret numerous things from this week's movement in the implied volatility curves. Recalling that implied volatility has a monotonically increasing relationship with option price (higher vol, higher price), these shifts down in volatility curves of closer dated tenures cause the corresponding options to be cheaper, both puts and calls. Since the shift was in the front end of the curve and the longer dated expiries didn't change much, this creates what would be called a steepened term structure of at the money vol.
Term structure of at the money vol refers to the plot of at the money implied volatilities on the y-axis and corresponding tenures on the x-axis. A trader can look at this graph (shown below) and interpret how option prices increase as one looks at subsequently longer tenures. There is no “regular” shape that the term structure must assume normally, however traders can speculate based on market conditions as to what term structure will look like, in the same way that they can speculate on direction or volatility levels. For example, if one believes that the graph is too steep between March 2024 and December 2023 expiries, one can short December options and long September options to express this view.
Neglecting the impact of directional movement on the net portfolio’s value, the position should experience positive PnL impacts from the term structure getting less steep. This reduction in steepness can only happen if December goes up relative to March, creating a flatter looking slope. In order to minimize this position's dependency on market direction (and thus minimizing the trader’s need to guess direction right) one would usually take long / short straddle positions to start out “delta neutral”. As time progresses and spot moves there may be residual delta building up (exposure to spot price), and the trader can decide to offset it by simply longing or shorting spot. For example, if the net delta of this position is 0.2, the trader could short 0.2 BTC in order to offset this exposure (this process is known as delta hedging).
Digging deeper into BTC Deribit and Paradigm block trade data we see the biggest volumes in Put Spreads, Risk Reversals, and Call Spreads (30.7%, 16.1%, 16%). According to Paradigm, the majority of put spreads were actually short, with about 1900 contracts sold and 300 contracts bought. Most were traded in September - October expiries which would explain at least some of the downwards movement in closer dated implied vols. Ethereum volume data shows a similar mix of vol / skew based combination spreads. The top 3 traded spreads were Put Spreads, Put Diagonal Spreads, and Call Spreads (20.8%, 19.8%, and 19%). Most of the Put Spread based activity for ETH was in September.
BTC Combo Spread Volumes:
ETH Combo Spread Volumes:
***Data and insights as of August 28th, 2023 15:00:00 UTC
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