Low Volatility in Crypto Markets

In recent months, we have witnessed record low implied volatility (IV) levels in the crypto markets. This has been somewhat discussed by a number of market participants, but we wanted to add our thoughts into the mix. This post will seek to examine the significance, implications and opportunities presented by the current low volatility environment from a Rysk Finance perspective.

The chart below illustrates the entire history of DVOL (Deribit’s 30-day ATM historical implied volatility) — clearly at its lowest levels. Based on this single dataset, one might be inclined to go long on volatility, since it’s ‘cheap’ relative to historical levels. However, we believe that relying solely on this metric is short-sighted, and does not provide options traders with the necessary context to determine value.

The Variance Premium

Deciding whether implied volatility (IV) is cheap or not depends on the realized volatility (RV) over an option’s lifetime. The variance premium (VP) is the difference between the IV and the RV. In this instance, it is calculated by comparing DVOL with the historical realized volatility. When the premium is negative, RV > IV. In such cases, being long volatility has paid off.

Calculating the average variance premium over the entire sample period gives us +8.79 (positive means IV > RV). This is consistent with the use of options as insurance products, where buyers of options are willing to pay a premium for the protection provided against potential losses and higher volatility in the underlying asset. Conversely, upon higher than expected volatility, sellers of options demand compensation as a reward for bearing the risk. As a result, the implied volatility of ETH options has been higher, on average, than the actual volatility of the underlying asset.

The most recent reading of the 30-day ETH historical volatility was 48.86, during a period where DVOL was 70.16 (VP = 21.3), indicating an above-average spread. However, if spot volatility remains at 48, it would fall back in line with the average, as the current DVOL sits at 57 (VP = 9).

Of course, the big question remains: What will volatility be in the future?

Sellers of implied volatility can only expect to profit if forward volatility is less than implied volatility. To help answer this question, let’s look at what drives volatility as a whole.

Shocks

Looking through academic and institutional research, there are many reasons attributed to volatility. While the study can be very detailed, at a high level it comes down to unexpected events or ‘shocks’.

A shock is an unexpected event for market participants. Expectations are important because if a market is positioned in anticipation of an event, there is liquidity readily available to support the market during that event.

The Expected Negative Event

The U.S. 2020 election serves as a prime example of a negative event that was priced in.

• In the days leading up to the election, there was fear of a contested outcome. The VIX, which measures 30-day implied volatility for options on the S&P 500, saw increased volatility due to uncertainty surrounding the election
• On November 3rd (election day), the VIX closed at 35.55, while the S&P 500 closed at 3369
• The day after the election, with Trump contesting the results, the VIX dropped to 29.57 (-16%) and the S&P 500 closed at 3443 (+2%)
• On January 6th, the day of the capital riots, the VIX closed at 25 (-15%) and the S&P 500 closed at 3748 (+8.9%)

This illustrates that a negative event can have the opposite effect on a market if participants have already positioned themselves for it.

The Merge

Ethereum forks often attract a lot of attention, causing market participants to position themselves for uncertainty ahead of time. On September 15 2022, Ethereum completed The Merge. As usual, there was no shortage of FUD. Critics argued that proof of stake would make Ethereum less decentralized and more vulnerable to new attacks. Prior to the event, DVOL had been bid up to 115, but on the day of the merge, it collapsed. As with other markets, expectations of market participants matter in crypto too.

A Maturing Market

Examining cryptocurrency as an emerging market can be helpful. As it matures and gains broader institutional and retail adoption, it also gains additional flows of liquidity. Liquidity is a key factor in suppressing volatility. In fact, according to some research, volatility is in fact, a measurement of market liquidity.

Looking at the previous bear market of 2018, the peak 30-day realized volatility reached a high of 250%. However, this time around, that level of volatility was never reached.

In the current bear market:

• Peak volatility came with the first shock of deleveraging in 2021 as realized volatility reached above 200%
• This primed market expectations for future shocks, with each subsequent shock realizing lower peak volatility:
  — The Luna crash came in under 150% RV
  — The subsequent FTX crash hit 100% RV
• The subsequent FTX crash hit 100% RV

Looking at the 2019–2020 trough of the previous bear market, realized volatility was at or below 50% for a good portion of the period. With the market being more mature and liquid today, it would not be surprising if we witness realized volatility below 2019 levels in the trough of this bear market. In such a scenario, it could be argued that implied volatility in the 40–50% levels would still be at a premium to realize.

That being said, if using shocks as a framework, one should ask “what shocks are not being priced in by market participants?”. In such a scenario, buying options could well pay off. Regardless of DVOL trading at 55% or 65%, a large shock would exceed IV in such events.

The chart below shows the rolling 7-day realized volatilities, where the blue band is generated by a time series forecasting library to predict future movements. Normally the volatility clusters are inside the blue band. This makes spotting shock events easy as they spike way outside the band of expectation.

For sellers of volatility, a shock would cause a drawdown. However, it’s important to remember that these shocks are what create the variance risk premium. Generally, following a shock, IV levels move higher to create a positive variance spread. By consistently selling volatility, one can harvest the variance premium over time. Risk management through series diversification, hedging, and not over-leveraging can all help manage shocks in a portfolio.

Riding Volatility at Rysk

For those interested in passively harvesting of the variance risk premium, Rysk offers a dynamic hedging vault that automates the option selling and risk management of such a strategy for LPs.

In Rysk Beyond, users will be able to purchase options to hedge against market shocks — just be sure to keep an eye on whether the rest of the market is pricing it in.

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