"BitMEX Talks Options: When Will Options Trading Go Live? Part 2"
I have written a lengthy article discussing the structure of the cryptocurrency derivatives market. Now, let's talk about 2020.
Table of Contents
The original article is reproduced from BitMEX, written by BitMEX CEO Arthur Hayes
Cryptocurrency Derivatives Roadmap for 2020
While cryptocurrency delta one products in the market can satisfy the needs of speculators, some wish to earn returns from their own coins, some need to pay bills in fiat without selling coins, and others need to manage their future returns.
Pursuing Returns
With relatively low volatility and range-bound price movements, the new cryptocurrency and decentralized finance (DeFi) crowd now seeks yields. Their "shitcoins" sit idle, so why not lend them out and see if something can be earned.
Without secure cryptocurrency bonds for investment, earning returns is nearly impossible. While the traditional bond market lacks cryptocurrency, speculators have been seeking borrowing opportunities. They must borrow to short cryptocurrency and to trade.
The challenge is to create a cryptocurrency inventory in a price-neutral manner. I will focus on Bitcoin, as it has the most developed and liquid derivatives market.
The simplest way to create a Bitcoin inventory is to buy Bitcoin and sell its corresponding futures. The steps are as follows:
- Sell $100,000, buy 10 Bitcoins.
- Sell 100,000 BitMEX March 2020 futures contracts (XBTH20). Now, you have completely eliminated any price risk. Assume you use only 50% leverage. This means you must deposit 5 Bitcoins on BitMEX.
- Lend out 5 Bitcoins OTC through a reliable counterparty, receive dollars as collateral in return. Currently, most loans are overcollateralized, so you will receive over 100% of the value in dollars or stablecoins.
If XBTH20 trades at a discount, you will price the loan at a certain interest rate to offset your hedging costs. If XBTH20 trades at a premium, you will earn profits through futures premiums and loan interest rates.
You must monitor your liquidation price. If the market rises, you can "create" more Bitcoins by selling fiat, buying Bitcoins, and selling futures to use as margin. In a bull market, the premium should expand, thus Bitcoin creation will earn a positive carry.
As the Bitcoin lender's loan balance increases, the loan rate will be similar to the quarterly futures annual rate. For those who dislike Bitcoin price volatility, this is a good strategy. But what about those who already hold Bitcoin? What returns can they earn from their inert magical internet money?
A strategy that will become more popular in 2020 is: covered call strategy.
Assuming the following scenario:
You own some Bitcoins and wish to earn returns by selling out-of-the-money bullish options. You currently hold 100 Bitcoins (XBT).
- Spot price = $5,000
- Bullish option at $6,000 strike price for 1 month = $500
- Trade: Sell 100 bullish options
Returns:
Current Income: $50,000 (which can be constructed to receive Bitcoins as option fees)
Bitcoin price increase: If after one month, the settlement price of XBT is above $6,000, you will deliver 100 XBT and receive $600,000.
Bitcoin price decrease: If after one month, the settlement price of XBT is below $6,000, you do not have to deliver, therefore you will receive nothing.
This trade can bring you a 10% net profit within a month. As the price rises, you hope to continue holding your Bitcoins; however, if it jumps 20% after a month, you would be willing to sell your Bitcoins. Since you already hold Bitcoins, if the price drops and shows a loss calculated by market value, you still receive the option fee. If the price rises, you cash out at an ideal level and earn premium income.
Who would do this trade? As mentioned earlier, speculators prefer trading Bitcoin/USD rather than paying 20% for out-of-the-money bullish options. However, if you are pursuing returns, you would not be overly sensitive to price. If the fair value is 12% monthly and you get 10%, would you really mind? Another approach is to continue retaining returns. Essentially, investors who are not sensitive to price but are determined to pursue yield will sell implied volatility at a cheap price.
Volatility traders sensitive to price would buy options when implied volatility is less than future realized volatility. These volatility traders make money throughout the option's term through delta hedging. If this sounds confusing, then you should not buy these options. This is a win-win structure for both buyers and sellers.
These trades will be negotiated through OTC trading. Bitcoin custodians will sell out-of-the-money bullish options in large quantities to major market makers. Subsequently, these custodians will offer monthly returns to customers who allow them to collateralize Bitcoins. Finally, a real source of income is opened up for cryptocurrency custodians.
Miners Get Smart
Amateur Bitcoin mining disappeared when ASICs were introduced in 2013. Growing capital expenditures require miners to operate on a large scale to remain profitable. At a certain scale, miners can roughly predict how many Bitcoins they will mine in a short period.
Unless miners have a robust balance sheet and enough fiat to pay for operational costs without selling Bitcoins, they must constantly strive to acquire fiat without selling Bitcoins. The Bitcoin collateralized fiat loan market was born out of this need. This trade does not involve derivatives. However, miners can earn income by estimating the bullish options corresponding to the future Bitcoins to be mined to pay for operational expenses.
Assuming:
You are a miner who must pay electricity and other operational costs at the end of each month. You are confident that you can produce 100 Bitcoins next month. You make the following trade to earn fiat income to pay end-of-month bills.
- Spot price = $5,000
- Bullish option at $6,000 strike price for 1 month = $500
- Trade: Sell 100 bullish options
Returns:
Current income: $50,000, part or all used to pay operational expenses.
Bitcoin price increase: If after one month, the settlement price of XBT is above $6,000, you will deliver 100 XBT and receive $600,000.
Bitcoin price decrease: If after one month, the settlement price of XBT is below $6,000, you do not have to deliver, therefore you will receive nothing.
Similar to Bitcoin holders, miners are relatively insensitive to price/implied volatility. Miners' main concern is paying their monthly fiat bills. If the provided option fee can meet these goals, miners will be satisfied. A small issue is how to provide collateral for the trade. Miners will only receive a total of 100 Bitcoins at the end of the month. However, traders need to immediately start delta hedging the option. This requires trust that if the bullish option settlement price is in-the-money, the miner will deliver all Bitcoins within a month.
If trust can be established between long-standing mining operations and large trading firms, liquidity can quickly enter the market.
Floating Rate Bitcoin Notes
Another interesting group of enthusiasts are fiat holders who want to earn income. Crossing roughly two difficult adjustment periods in a month. With enough confidence in the future price and hash rate for one month, you can roughly predict how much efficient miners can invest $1 million to produce monthly returns. You can offer floating rate notes, where the rate is fixed monthly. This product can be called Floating Rate Bitcoin Notes (FRBN). The yield for each period will be set based on the hash rate and price at the beginning of the month.
If Bitcoin soars, the USD mining return will be higher. If prices decline, the issuer may produce Bitcoins below cost. The 30-day hash rate volatility is much lower than Bitcoin. Therefore, the risk that must be hedged is price risk. To hedge downside risk, the issuer needs to purchase put options close to their production cost.
Cost = Electricity Costs + Data Center Rental + Mining Equipment Depreciation
To fund the purchase of put options, the issuer can sell an out-of-the-money bullish option. The collar option structure is cost-neutral. If such an option structure can be used, the issuer can confidently set the floating rate monthly.
Assuming:
You are the issuer of Floating Rate Bitcoin Notes. In the next period, FRBN will pay a 3% rate. You sell $1 million worth of FRBN. To hedge price risk, you need to construct the following cost-neutral collar option structure.
- Cost = $3,500
- Hash rate remains unchanged in the next two difficult adjustments.
- 1-month projected Bitcoin return = 100
- Spot price = $5,000
- Bullish option at $6,000 strike price for 1 month = $500
- Bearish option at $4,000 strike price for 1 month = $500
Returns:
Current cost: + $50,000 (from selling bullish options) - $50,000 (paid for buying bearish options) = 0
Bitcoin price increase: If after one month the price is above $6,000, you will deliver 100 XBT and receive $600,000. The bearish option expires worthless.
- Mining profit: $600,000 - $350,000 marginal cost of producing 100 Bitcoins = $250,000
- Yield: $250,000 / $1,000,000 = 25%
- Issuer's profit: 25% - 3% FRBN guaranteed yield = 22% * $1,000,000 = $220,000
Bitcoin price decrease: If after one month the price is below $4,000, you will deliver 100 XBT and receive $400,000. The bullish option expires worthless.
- Mining profit: $400,000 - $350,000 = $50,000
- Yield: $50,000 / $1,000,000 = 5%
- Issuer's profit: 5% - 3% = 2% * $1,000,000 = $2,000
The other side of this trade is the large trading firm. As the issuer, you must purchase a put option with a strike price of $4,000 to ensure profit in a downturn. As long as the bullish option profit can offset the cost of the put option, you do not have to worry about the exercise price of the bullish option. The trading firm will handle the exercise price of the bullish option to ensure they can profitably hedge the cost-neutral collar option structure's delta.
Over-the-Counter (OTC) Reigns Supreme
OTC spot trading companies experienced a major shakeout in 2017. Today, only the strongest balance sheet companies can survive. Competition has led to narrower spreads and a drastic drop in trading volume. After enough time and experience, spot trading has almost always become a fully competitive market.
I have no sympathy for easily deceived investors who put funds into OTC platforms with income multiples of over 1x. The only IP that appears as a result is the telegram chat room.
There is definitely a demand for these types of structured options trades that offer income and cash flow. Given the current liquidity and margin requirements of cryptocurrency options trading platforms, these trades cannot be executed online. OTC platforms that employ a group of smart traders in practice will have the opportunity to increase their profitability in 2020. Those who can price and trade option structures and then hedge profitably without parceling out the common option components to a broader market platform will face huge demand.
With the growth of the OTC market, trading volumes of short-term common bullish and bearish options will also increase. Online trading will gain liquidity through this method.
2020 Will Be Interesting
Wars, elections, and viruses have entered people's consciousness in 2020. Your health and the "enjoyment" of your political system may be completely overturned by the end of this year. What to buy and sell in times of fear? Traders who anticipate what the masses perceive as safe and harmful assets will profit greatly this year.
After nearly a decade of volatility suppression with the help of central bank money printing, life seems to present unpredictable scenarios. Bitcoin needs to prove its value as true hedging assets are macroeconomic fluctuations. With the low trading volume phase passing, cryptocurrency traders will be pleased. Those who claim income from their computer-generated currency tools will be able to sell in volume and save funds. Like an episode of Oprah, everyone will benefit from the intensified Bitcoin volatility.
If you have truly read the entire series, congratulations. I will review how the derivatives market copes with the winter and spring of 2020 before summer vacation.
Related Reading
"BitMEX on Options" When to Trade Options? (Part 1)
Derivatives Become the Main Battlefield, Binance Futures Weekly Trading Volume Breaks Records, Deribit Launches Ethereum Options
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