A look beneath the price-volume surface

Closing out the chapter

As we watch 2021 depart in our collective rear view mirrors, I think there’s no better way to close out the year than a confluence of (1) a broad-based crypto correction, (2) an energy crisis cascading across the Northern Hemisphere and (3) a new SARS-CoV-2 contender with transmissibility that knocked measles down to silver on the podium (Omicron R0 around 14 – 21).

Total Liquidations

4th December served as a reminder to the 5-10X levered folks that a 10-20% correction will not give you the opportunity to post collateral before your broker closes you out.

Frigid Europe

Javier Blas (Twitter): “With the exception of Poland and Scandinavia, all Europe is above €300 per MWh (France and Switzerland near €400)”

Maybe it’s not that virulent…

French COVID ICU 7-day exit rates, data since beginning of Pandemic. Notice how across the first three waves, the 7-day exit rate has hovered around 20%.

Preliminary data from this 4th wave that began in Guateng, South Africa, suggests ~100% of Omicron ICU admissions are out the door in 7 days or less!

Caveat: case load, thus far, are mostly young and healthy; it is tempting BUT DANGEROUS to extrapolate!

When Santa visits this year he better show up with a valid vaccine certificate and a negative PCR test no older than 48 hours. Milk and cookies by the nightstand replaced with hand sanitizer.

The behemoth below the price-volume surface

Our transition into 2022 was marred by a, relatively mild, crypto correction that helped remind us all the volatility inherent in hodling these assets. This is a dilemma Cypherpunk Holdings (CSE:HODL) wrestles with on a daily basis. Our investment thesis is founded on the primacy of algorithmic and participatory consensus – whether that be Proof of Work or Proof of Stake. Bitcoin and Ethereum are tokenized manifestations of that meritocratic will and HODL’s curation of these asset tokens represent our confidence in these networks to continue generating compelling value for users. Crypto is still early – very early. 

There remains much work to be done to enhance the crypto user journey and the end user experience so that sovereignty over money and data are no longer confined to the realm of technically minded and savvy. We have vested confidence in the ability of blockchain networks to become the future payment rails for billions of users. We have also vested confidence in the ability for these networks to serve as the foundation upon which economically value-adding activities can be carried out. Any service in existence, and any services one would care to imagine, can be instantiated in a decentralized app ecosystem. 

It’s important to stay in the game – it pays to be long – but do so in a way that also pays heed (and respond) to the undercurrents of downside risk and volatility clustering that causes systemic underperformance in pureplay long only portfolios relative to dynamic risk-on / risk-off portfolio management approaches. To straddle the goals of net long exposure and downside risk management, Cypherpunk looks to the crypto derivatives market for clues. Our preferred platform is Deribit.

Funding Rates

Funding rates represent market participants’ sentiments in the perpetual swaps market. Positive funding rates come part and parcel with a bullish regime. They indicate that long positions are dominant and pay a funding cost to shorts to keep those positions open. 

The deleveraging that occurred on 4th December flipped funding rates negative and kept it in negative territory for a week before stabilizing. Bitcoin funding rates have since reverted to neutral. The fact that BTC funding rates tend to be positive more often than negative from August to November indicates general bullishness over that period. We shall see whether that regime returns in H1 2022.

Compared to bitcoin, ETH certainly has a lot more enthusiasm behind it judging by its ratio of positive to negative funding rate momentum (funding rate momentum calculated as the sum product of the rate and the instances). ETH funding rate is firmly in positive territory and has been for at least the past week.

Open Interest by Hour and Expiration

Open Interest reflects the number of outstanding contracts in the market (both primary and secondary). Each contract has a buyer and a seller.

On the LEFT, we see heavy clustering and concentrated volume in trading of options instruments with 3 month expiration expiring on 31st December 2021.

On the RIGHT, we see that moving the expiration date one week into the new year the volume in open interest for 3 month maturities drops by over 90%.

Market participants have made a call as to where they think the price of bitcoin will land by year end. However, these same participants are far less willing to take a position on 2022 until price action manifests itself at year end to provide clarity.

Open Interest: Notional Value & Contracts Outstanding

LEFT: Notionally, there’s 7.73B USD in open calls and 3.4B USD in open puts across all expirations.

MIDDLE: 5.78B USD worth (113.4K contracts) will expire and resolve by 2021 year end.

RIGHT: the distribution of open interest across strikes is skewed toward the upside; roughly 30% of open contracts are for strikes below 50K BTCUSD and 70% are above.

Cypherpunk has already positioned itself to ride this asymmetric bet going into Q1 2022.

Coin Premium

Speculation is concentrated around 2021 year end and 2021 end of quarter 1 with put premia taking the lead. Notice that concentrated clusters of open interest to the right representing 250K and 400K strikes respectively. Those are most definitely deep Out of The Money (OTM) calls. It’s not to say BTC will reach those lofty heights any time soon but rather those far OTM calls tend to be favored by speculators as they are relatively inexpensive at current spot levels and their value can accelerate rapidly as prices recover from here.

Net Delta Exposure

BTC Option Delta is the change in the value of the option with respect to changes in the price of bitcoin. Positive open interest suggests net calls outstanding while negative open interest points to net puts outstanding.

We see call dominance at 2021 year end leading into the first week of January 2022 around 50K call strikes. Delta then flips to negative at the end of January around 60K put strikes, thus signalling the market’s anticipation of a slight pause or correction at that point.

At-The-Money (ATM) Implied Volatility (IV)

30 days until expiration…

Between 1st and 4th December 2021, BTC corrected 28% which shows up in the IV spike from its 73 baseline to 103 (LEFT) before quickly falling back once those spot levered longs were taken out. In the derivatives space, BTC long puts booked profit and long calls stopped out. 

The right chart is Deribit’s 30/20 Skew which measures the difference in IV between calls (0.2 to 0.3 delta) and puts (-0.2 to -0.3 delta). It provides a gauge for how expensive calls are relative to puts.

In the 30 days to 23rd December, we see that calls with 30 days expiration traded from a 10 – 12% discount relative to puts to around par.

90 days until expiration…

The picture is almost identical to 30 days.

All expirations…

When we account for all options across all expiration dates we notice that the call option discounts are much more moderate relative to shorter term maturities, with calls trading 6 – 8% below par to 6th December and then showing that same recovery trend to par.

Looking at this from a supply / demand perspective, it is arguable that interest on the long side is building and the balance of risk is shifting from that of long exposure in BTC to short exposure.  

Bitcoin Implied Volatility

BTC implied volatility shown above gives the 30 day (forward-looking) annualised expectation of volatility. The chart above shows BTC implied vol since 31st March 2013. The vol structure is trending toward a structurally lower vol environment over time – indicative of a ‘coming of age’ for bitcoin as it transitions from a niche asset held mainly by crypto zealots (sorry, no offense intended) to an asset class courting both retail and institutional participants. 

It should therefore come as no surprise that with the transitioning into this more stable vol regime, BTC prices have also grown exponentially. Still, there remains much work to be done on the blockchain and the product to make bitcoin the medium of exchange that was envisioned in Nakamoto’s original paper. Until then, learn to enjoy the rollercoaster rides!

Over the course of 2021, BTC saw two major vol spikes that saw it deviate from trend. The first was in February on the back of bitcoin’s stellar rise, cracking the 50K USD price level. The second was in May-June when it corrected heavily and sank below 35K USD. Notice how in the latest Nov-Dec correction (~30% drawdown from peak) implied volatility never quite spiked the way it did on those two earlier occasions? The most recent correction was more about deleveraging than it was about sentiment. The ‘fear factor’ was mostly manufactured by the pent up euphoria of irresponsibility levered longs. The $1.58B USD worth of positions that underwent liquidation on 4th December quickly put an end to the crisis. From there, it was mainly about making the climb back above 50K USD…and now we’re there!

Final Word

None of the above is meant to be predictive. The purpose of presenting this information is to encourage readers to look beyond, and beneath, the price-volume surface in their respective risk management exercises. The way I and my team at HODL sees it, there are two ways to hodl:

  1. Accumulate crypto through buy only and never selling; or
  2. Accumulate crypto through active position management that generates surplus capital for further opportunistic buying.

As professional asset managers, option 1 is not an option for us since it does not deliver value to investors over and above what they can already do in their own brokerage account. The latter is what enables Cypherpunk to generate alpha – it is a mantra enshrined in our company’s mission statement

2022 is shaping up to be a year of contrasts for asset markets and crypto. From US Congressional hearings into crypto, it looks like Congress is starting to put pressure on SEC Chair Gary Gensler to allow US ETFs to hold the underlying (and not just CME futures) on their books. Institutional validation aside, when Congress is telling the regulator to essentially ‘get with the times’, you know you’re living in extraordinary times!

A Merry Christmas and Happy New Year to all our followers.

References

https://www.coinglass.com/options

https://www.coinglass.com/funding/BTC

https://www.coinglass.com/LiquidationData

https://www.theblockcrypto.com/data/crypto-markets/futures

https://www.theblockcrypto.com/data/crypto-markets/options

https://www.coinoptionstrack.com/options/BTC/gainers

https://metrics.deribit.com/futures?index=BTC

https://www.deribit.com/statistics/BTC/options-data

https://insights.deribit.com/exchange-updates/dvol-deribit-implied-volatility-index/

https://insights.deribit.com/industry/tranquility-in-the-eye-of-the-storm-weekly-market-review-from-blofin/

https://insights.deribit.com/option-flows/option-flow-week-50-2021/

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