"BitMEX Talks Options: When Will Options Be Trading? (Part 1)"

Any self-respecting cryptocurrency speculator will ask themselves the following three questions:

The original article was reproduced from BitMEX, authored by BitMEX CEO Arthur Hayes.

When will it skyrocket?
When should you buy a Lamborghini?
When will options have liquidity?

If I knew the answers to questions 1 and 2, HDR Long Term Capital Management wouldn't be a figment of my imagination, but a high-fee hedge fund that rivals Renaissance Technologies in returns. By the way, I recently read in an article that since its inception, Ren Tech has earned over $100 billion in net profits after deducting some negligible costs. Jim Simons is a master in the investment world, he's truly amazing.

However, as the CEO of the largest cryptocurrency derivatives trading platform, I do have some insights into the third question. For those who decided to read fewer books and post more on Instagram in the new year of 2020, here's a summary:

Liquid cryptocurrency delta one (delta value equals 1) trading products allow traders to trade without flooding traditional electronic options trading platforms like trading traditional asset classes. But this doesn't mean these volatility products won't gain liquidity. As more participants rediscover the need to stabilize volatile cash flows and earn returns on their bitcoins, insurance products and yield products with embedded options will become increasingly popular. These structured products will lead us to a more mature cryptocurrency derivatives market, and liquidity will seep into ordinary options traded by experienced traders. BitMEX will provide services in areas where we can add value.

Delta One Dominates

Traders use delta one products to gain leveraged directional risk on an asset. When traders have foresight into the market, they always want more leverage so they can make more money. Traditional trading platforms and exchanges (except shady CFD brokers/illegal brokers) only offer limited leverage.

Unless you're a large hedge fund, bank, or financial institution, you won't be able to get significant leverage. Exchanges protect potentially bankrupt traders by limiting leverage. The most liquid stock futures contract globally is the CME's Globex S&P E-mini contract. I believe the exchange offers leverage up to 5 times the initial margin. It's not surprising to have 5 times leverage when the daily substantial movement of the underlying is considered 1%.

Brokers may offer higher leverage for forex trading, but it's becoming increasingly difficult to get 100 times or higher leverage. Even if you can get high leverage, these exchanges or brokers won't limit your losses. In January 2015, when the Swiss National Bank removed the cap on the Swiss franc against the euro, some brokerage firms were sued by clients for massive losses. It's not a good practice.

Due to low leverage provided at the exchange level and high leverage offered by brokers (with the risk of losing everything), traders seeking secure leverage inevitably turn to options. By buying out-of-the-money call and put options, traders can enjoy higher leverage with limited losses.

Out-of-the-money options trade cheaply because the distance between the strike price and the current spot price is significant enough to suppress the premium. You pay less for outcomes with lower probabilities. If a trader is wrong, they only lose the premium. This way, traders can construct leveraged convex trades.

Another (and arguably more important) aspect that lowers the premium is the low volatility levels of securities, fixed income, and currencies. If the asset price changes are small and out-of-the-money, the premium will be cheaper, offering a higher leverage ratio.

Due to this market structure, options attract speculators. In turn, speculators bring liquidity to both sides of the market. Trading becomes about finding cheap convexity. Traditional asset class options markets offer convexity, leverage, and security to speculators. Delta one products lack these features, therefore, speculators are adding liquidity and volume to the options market.

Cryptocurrency derivatives have a completely different market structure.

Suing clients is a bad practice, and because margin currencies like bitcoin are hardly considered real money, it's almost impossible. Therefore, all platforms take a limited loss position from the start. Regardless of the size of your position, you can only lose the initial margin on BitMEX.

There's no such thing as a free lunch unless you're a politician running for office. If traders can only lose the capital they put in, then in volatile markets, profitable traders won't be able to enjoy all their unrealized profits. In some cases, the market can gap up or down, and the platform doesn't have enough equity to pay out all the profits in full. This is when a socialized loss system is needed.

A socialized loss system ensures that the platform has the ability to pay under all market conditions. Cryptocurrency trading platforms didn't start by selling seats to wealthy institutions willing to gamble their balance sheets online, allowing speculators to trade with 100 times leverage on one of the most volatile assets in human history.

I can only speak for BitMEX, but if bitcoin suddenly goes to zero or infinity, we have the ability to pay. This is the security provided by our socialized loss system.

Limited loss and socialized loss margin system theoretically sound appealing, but without a third component, namely, an insurance fund, it's still insufficient. In a two-sided trading system where one goes long and the other goes short, the return on equity (ROE) is capped at 100%. That's because you can only win the money the other party puts up as margin. The platform can offer 1,000 times leverage, but it's all talk. If you can't materially boost your ROE above 100%, the so-called leverage is meaningless.

To achieve an ROE above 100%, additional funds are needed to pay winners when losers go bankrupt. Traditional exchanges work with clearinghouses, with the final guarantee provided by the clearinghouse holding guarantee bonds. Usually, seat holders must purchase these bonds; in return, they charge fees for each trade.

However, if I came to you in 2015 asking for some bitcoins to help traders trade with 100 times leverage, you might laugh. BitMEX and other platforms had to find another source of funding to support the market. That's where the insurance fund comes in. BitMEX's insurance fund currently holds about 33,500 bitcoins.

Don't be timid, just do it: With the insurance fund, the potential ROE in the socialized system rises above 100%. Mathematically, the larger the insurance fund, the greater the potential ROE for new trades. The number of traders on both sides of the market with different price expectations also affects potential ROE. The more bets there are, the greater the likelihood of liquidating a stop order at a price better than the bankruptcy price in the market. Therefore, the insurance fund will grow.

Assuming all active users on cryptocurrency derivatives platforms are equal (I can assume BitMEX has the most active users, but I can't verify this without knowing the active user base of all competitors. Unfortunately, I don't have that information). The only publicly available data released by all socialized loss platforms is their insurance fund. BitMEX's fund is the largest in magnitude. Therefore, on BitMEX, traders have the highest potential ROE before trading.

If we assume the insurance fund balance is non-zero, then the cryptocurrency delta one market begins to offer some attractive convexity for traders. Imagine:

Traders can only lose the capital they put in. Their downside losses are limited.
Whether going long or short, traders make more profit when they're right than when they're wrong. This means their return status is always convex.
Traders can use high leverage.
Essentially, the cryptocurrency capital market structure has packaged options as a type of delta one product. The return status of cryptocurrency futures or perpetual swaps hasn't changed. In terms of leverage, a 1% price increase is equivalent to a 1% increase in the contract. However, based on ROE, when traders buy options, the premium is used as the initial margin.

Cryptocurrency Options

For years, various cryptocurrency platforms have offered options markets. While liquidity is certainly better than when I entered the field five years ago, the market still lacks significant liquidity. Electronic markets for call and put options at various strike prices in cryptocurrencies lack "adequate" liquidity, leaving many traders disappointed.

Traders who cut their teeth trading stock and forex options hope to use the same trading tools in cryptocurrencies. However, while perpetual swaps in cryptocurrencies are likened to Gatling guns, cryptocurrency options are just rifles. If you dare, go for it.

Trading options is much more complex than trading futures and swaps. Delta, Vega, Theta, Rho, Gamma, dVega/dVol, I can go on about options Greek letters. I still remember the weekly quizzes on options math during my internship in the derivatives sales department at Deutsche Bank and the managing director who taught me the Greek letters. Since the volatility sales and trading department employs only tens of thousands of people rather than millions, most traders across industries hardly understand the pricing of these markets.

A good example: One day, I sat with a trader trading variance swaps. Variance swaps allow traders to keep constant vega across all strike prices. If you don't know what this means, you're in for a treat. The trader had a fancy spreadsheet that could calculate all options Greek letters and display daily profits and losses. All he had to do was hit F9 to generate quotes. I asked him how these were calculated. He said he didn't know; it was made by a financial engineer, and he just followed it blindly.

The moral of the story: This stuff is really complicated.

Strike! If the same return status can be generated, traders will always do the simplest thing.

Cryptocurrency volatility is very high. We're currently in a low volatility regime, with a 30-day realized volatility of about 40%. When pricing options, the higher the volatility, the higher the price of call and put options. Therefore, option buyers (speculators) need to invest a significant amount of capital to engage in convex trades. For options fees to be cheaper than the most liquid cryptocurrency derivative, BitMEX's bitcoin perpetual swap, the option fee must be less than 1%. When the underlying asset has such high actual volatility, this is impossible.

Strike two! Traders will always prefer products with the highest leverage.

Market makers, I haven't forgotten about you. Every buyer has a seller. Shorting options is a tough business. If volatility is high, the margin requirements for option sellers will be very expensive. Market makers must be able to sell unsecured options when quoting. Selling unsecured call options on assets like bitcoin, which surged 40% within a few hours when President Xi Jinping mentioned "blockchain," is risky. As a result, the margin system used by various platforms is very conservative.

The same group of cryptocurrency market makers quote cryptocurrency delta one and options products. They have to decide how to allocate capital. If the option requires more capital due to margin requirements, has less liquidity due to lower awareness, and offers lower leverage, they will provide less liquidity. If brave speculators go to trade options, and the price difference is the cost of a Tesla Cybertruck, traders will quickly return to trading bitcoin against the dollar.

Strike three (strikeout)! Traders prefer products with liquidity over illiquid derivatives.

I hope you are satisfied with this analysis of the cryptocurrency derivatives market structure and understand why speculators prioritize delta one products over options.

Delta One:

High leverage
Limited loss, meaning the maximum loss is the initial margin of 100%, but the maximum upside is far beyond 100%. Also known as convexity.
Liquidity
Options:

High implied volatility leads to high option premiums, meaning lower leverage ratios or magnification.
Limited loss because you can only lose the premium.
Lack of liquidity
After discussing the unfeasible scenarios, in the next column article, I will discuss the options/volatility product categories that I believe will be popular in 2020.

Glossary

For those who didn't understand what I just said, that's okay. Here's a glossary:

Delta – The change in the value of a derivative contract relative to the change in the price of the underlying asset.

Delta One – A derivative product with a delta value of 1. Used to refer to futures and swaps products in the cryptocurrency field. During my work, I was an intern delta one trader.

Socialized Loss System – The mainstream margin system used by all liquid cryptocurrency derivatives platforms. In this system, if there's not enough funds to pay winners due to bankrupt losers, the unrealized profits of winners will be reduced, or their positions will be liquidated early.

Initial Margin/Limited Loss – A supplement to the socialized loss system. Traders can only lose the initial margin of their position. The trading platform cannot chase their outside system financial assets. This is different from most brokers offering any derivatives/leverage trading, where if the loss exceeds the initial margin, they can and will chase the entire financial net assets of the trader.

Insurance Fund – This is a fund that is part of the socialized loss system. At BitMEX, if you're liquidated, the system takes over your position and liquidates it in the market. If there's remaining equity after liquidation, those funds are placed into the insurance fund. Losers contribute the remaining equity to this fund. When a liquidation order can't be filled at a price higher than its bankruptcy price, the fund is used.

Volatility Products – Derivative products with a delta value greater than 1. Used to refer to all types of options products. When trading options, you must trade not only based on direction but also based on convexity and yield.

Convexity – The asymmetric nature of the return curve. Convex trades refer to trades where you make more profit when the asset price moves up and down, compared to when it moves down. Buying options is a convex trade. Concave trades refer to trades where you lose more when the asset price moves up and down, compared to when it moves down. Selling or writing options is a concave trade. Convexity isn't free; the price of this return status is the premium attached to any option.

Yield – A trade that generates fixed, known returns before expiration. Selling covered call options is a yield trade. For example, a miner expects to mine 100 bitcoins within a year, they sell 100 covered call options at a strike price of $10,000 for December 2020 on bitcoin/USD, and receive 20 bitcoins as a premium from the buyer. The miner knows from prior experience that regardless of the settlement price of bitcoin within a year, the trade will generate 20 bitcoins of income.

Further Reading

• Derivatives Market of Exchanges: Daily Trading Volume Exceeds 20 Billion, Leveraged ETFs Become New Growth Point

• Derivatives Become the Main Battlefield, Binance Futures Weekly Trading Volume Breaks Record, Deribit Launches Ethereum Options

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