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BTC is once again exhibiting signs of bullishness as we commence the week with a remarkable overnight surge of more than $1200, bringing it to $28,350. Last week's quarterly expiry day remained relatively subdued, with minimal market activity actually happening on that Friday. This reinforces the notion that all major rebalances had indeed occurred earlier, and all significant gamma exposure had been rolled over by that time. The front-end (short expiry) at-the-money volatility experienced a significant drop last week, reaching sub 30 vol for the first time in weeks. As we enter this week, the Bitcoin volatility surface enjoyed a nice lift, displaying a positive spot-vol correlation. Expiries less than 30 days away sit at 30 - 35 vol while November, December, and March atm volatilities are at 38.47, 41.55, and 47.81 respectively.
Ethereum, too, has seen a notable increase in its vols since last week, with shorter-term expiries gaining more than 5 points and longer-dated expiries moving up by about 3 to 4 points. Despite this, Ethereum's at-the-money volatility remains 4 points lower than Bitcoin for expiries exceeding 30 days. Nevertheless, it's worth noting the higher convexity in the smiles as out-of-the-money volatilities increase faster than on BTC smiles, making Ethereum's "wings" more expensive.
This week, we will delve into the concept of convexity and its relevance to the options market. Convexity is a mathematical term that describes the curvature of a function or graph. To illustrate, a straight line exhibits zero convexity throughout (as it lacks curvature), while a parabola displays positive convexity. The degree of convexity depends on the intensity of the curvature. For instance, consider the graphs below depicting the 7-day and 30-day smiles. It is evident that the 7-day smile has considerably lower convexity compared to the 30-day smile due to its less pronounced overall curvature.
We can analyze the convexity of volatility smiles and assign significance to it both in theoretical and practical financial contexts. A higher convexity smile signifies that the implied volatility increases more rapidly as you move away from the at-the-money (ATM) point, in contrast to a smile with low convexity. Consequently, out-of-the-money (OTM) options are relatively more expensive. Some traders may recognize this characteristic and opt for a portfolio that aligns with their perspective on current or future convexity levels. For instance, when convexity is low and a trader holds a bullish view on implied volatility, they may choose to execute a long strangle instead of a straddle to speculate on volatility. In this scenario, OTM options are more affordable, and the strangle also benefits from an increase in convexity, unlike the straddle. Both portfolios are long volatility, but the strangle gains an additional advantage from an increase in convexity since the wings will move higher, even if the ATM level remains constant.
Traders seeking even more direct exposure to convexity can explore an iron butterfly position. An iron butterfly involves a short ATM straddle and a long strangle. This portfolio is inherently long convexity and can generate a profit even if the entire smile does not shift. This is because when the smile becomes more convex, the volatilities of the outer wings of the position rise faster than the ATM volatility, as otherwise, the curvature could not have become steeper. Since the trader is long the OTM options and short the middle, this contributes positively to their portfolio's performance.
This week we see the combination spread volume shift back towards long directional / long vol dominance. This is also the first time in the past few weeks that put spreads aren't in the top 3 for combination spread volume in BTC and ETH. BTC Deribit and Paradigm block trade data shows that the biggest volumes were in call diagonal spreads, call spreads, and 1x3 call ratio spreads (23.7%, 16.3%, and 12.5%). Ethereum shows the highest volumes in call spreads, risk reversals, and strangles / straddles (30.4%, 22.1%, 16.5%).
BTC Combo Spread Volumes:
ETH Combo Spread Volumes:
***Data and insights as of October 2nd, 2023 12:00:00 UTC
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