Every Friday, DeFi option vaults put downward pressure on implied volatility, opening the door for savvy traders to short-sell volatility ahead of the event.
Once upon a time, directional traders who bet on bullish or bearish price trends dominated the cryptocurrency market. Another type, known as volatility traders, has emerged in the last year. These traders bet on an increase or decrease in implied or expected price volatility over a specific time period.
These entities are increasingly employing strategies to profit from publicly available market information, most notably the weekly automated options strategies auctioned by decentralized option vaults (DOVs). Every Friday at 11:00 a.m. CST (7 a.m. ET), the vaults open to anyone willing to deposit their coins and earn double-digit annualized returns.
Each Friday, these vaults sell higher strike, or out-of-the-money (OTM), calls and lower strike OTM puts, lowering implied volatility. Sophisticated traders are almost certainly ahead of the drop in implied volatility. The strategy is similar to taking a typical short position in the spot or futures markets in order to profit from a price decline.
“DOV auctions reduce volatility and [options] premium prices,” according to Two Prime’s DeFi options explainer, which was published on April 8. “Because these auction times and mechanics are public knowledge, volatility sellers across short-term tenors, such as Two Prime, can profit from short-selling [volatility] in advance of these auctions and buying during and immediately after the auction event.”
Options are hedging instruments that provide the buyer with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. A call option grants the right to buy, whereas a put option grants the right to sell. When there is a lot of uncertainty about future price movements, there is a lot of demand for hedges. As a result, increased demand raises implied volatility and option prices, while option selling lowers both.
Decentralized option vaults have made otherwise complex options trading easier for retail investors. All users have to do is deposit their coins in the vaults, and the vaults will handle the complexities, such as determining the appropriate strike price for selling OTM calls and puts. The premium received from selling options represents the trade’s yield and is distributed among users in proportion to their deposits.
DOVs have grown rapidly in the last year to become an important part of the DeFi options ecosystem, with a total value locked of nearly $1 billion (R14.7bn), according to data source DefiLlama. According to Two Prime, the DOV-powered weekly covered call and covered put strategies are two of the most popular trades, with over $100 million(R 1.4bn) in notional exposure currently added to the market, driving implied volatility and option prices lower.
The chart above shows that on the crypto options exchange Deribit, the ether implied volatility index (ETH DVOL) tends to fall in the hours leading up to the weekly auctions held every Friday and rise after the auctions conclude.
“The Deribit Implied Volatility Index, a measure of implied volatility on BTC and ETH options, has trended lower into the auctions period in 2022,” Two Prime said. “Volatility has fallen for 100 percent of occurrences 4 to 7 hours before the auction as short open interest pushes [options] premiums lower,” Two Prime said.
The pattern has created a window of opportunity for savvy traders to sell volatility ahead of the auction by taking a short call or put position and closing the trade at relatively low prices due to the auction-induced decline in implied volatility.
“The strategy has proven to be quite popular,” said Robbie Liu, senior researcher at Babel Finance. “It was very profitable at first, but as time passed, more and more traders began to do this. As a result, profitability has been rapidly declining.”
Volatility selling is a high-risk venture.
Traders who write or sell options in order to profit from an impending drop in implied volatility are vulnerable to large price swings.
When implied volatility is too high in comparison to its lifetime average and historical volatility, traders typically sell volatility (via short put or call). Traders, on the other hand, buy volatility (via long call or put) when implied volatility is low in comparison to historical standards.
While implied volatility is moving away from the mean, there is no guarantee when it will do so, and there is no upper limit to how high it can go. In other words, implied volatility can remain elevated for a longer period of time than volatility sellers can remain solvent.
Furthermore, if the buyer exercises the option to purchase at an agreed-upon price, the call option seller is obligated to sell the asset to the buyer.
In theory, the seller is exposed to unlimited losses, while the buyer can profit from an unlimited rally in the market. Similarly, in a falling market, a seller’s account can be wiped out by a put ” Selling option premium results in convex risk/reward profiles that frequently outperform simple long/short futures or spot trading strategies. Back-tested versions of these strategies have performed well in some environments, but have also seen significant drawdowns when markets move outside of the expected range “Two Primes have been noted.