Working through max pain – How crypto is starting out 2022

Happy New Year. It looks like we started the new year with a continuation of the correction we saw during NOV and DEC 2021. In spite of the lacklustre start, 2022 holds a lot of promise for crypto – but expect a bumpy ride as always. The expected onset of regulation will be interpreted as a headwind. Personally, I think it will be a massive buy the dip opportunity for those with timing and dry powder on the side. I think institutions will take full advantage of any panicked and flash selloffs that could follow such announcements from the SEC, Treasury or even the Fed. But we’re getting ahead of ourselves.  Let’s take a moment to review the market signals that could highlight movements over the coming 60 – 90 days.

Crypto market state of play

In the chart above, the ‘market cap’ does not reflect the total market cap of crypto but the proportions are roughly accurate on a relative basis. Nonetheless, the 1 month rate of change is interesting.

It is rather surprising to see DeFi and Layer 2 to hold up so well relative to Layer 1 given that the latter is dominated by BTC, ETH and stablecoins a distant third. Exchanges (CeFi) like Coinbase, Binance, FTX and Gemini closely tracked BTC and ETH and unsurprisingly they fared almost as badly. Gaming remains one of the most volatile asset classes in crypto but its rise has been nothing short of phenomenal. The sector grew from a negligible base almost 2 years ago to a height of around 30B USD at the start of Q4 2021 before correcting.

The crazy thing about crypto gaming is that, to date, it’s managed to attract anyone except gamers. So they haven’t even started tapping their core market yet. Most of the development effort has been directed towards in-game economics, tokenomics and yield mechanisms and balancers to first attract the ‘earn’ crowd as a means of cost-effectively building rapid adoption and network effects primarily across emerging markets.

January lull for futures open interest

Futures open interest (OI) in nominal USD terms fell 37% from a peak of 816M on 31 DEC 2021 to 517M on 12 JAN 2022. Futures OI is the lowest in over 6 months with the last low put in on 25 JUN 2021 following the MAY selloff. Interestingly, OI for perpetual swaps (or ‘perps’), despite having dipped, did not fall anywhere close to those JUN / JUL lows. Investors tend to use perps as a proxy for spot bitcoin since, despite being a futures product, it has no expiration date. It’s indicative of the fact that the correction, which began mid-NOV is characteristically unlike the much bigger selloff that occurred mid 2021. This is reaffirmed by bitcoin forward 30-day implied volatility (or DVOL) on the right. DVOL is a proxy for the cost of insurance and it stayed mostly flat during NOV-DEC and is now trending down. So despite the correction in BTC, investors do not appear to be in a rush to buy and bid up the price of insurance.

Options open interest

OI by volume has dropped to close to those JUL 2021 lows. In both instances, BTC corrected aggressively and we saw liquidations rise. In more mature equities derivatives, periods of high volatility and uncertainty generally results in increased options activity. A fall in OI volume on Deribit during drawdowns suggest those options are being used in leveraged plays rather than for hedging purposes. Looking at volume by instrument, out-of-the-money (OTM) calls and puts are again the flavor of the month. This, again, points to the speculative use of options as opposed to hedging and risk management.

Options OI by expiration indicates prices are likely going to be pinned in a range dictated by those 28-JAN and 25-MAR expirations. Judging by the maximum pain price (MPP*) that range is expected to be 48K – 50K USD. The market is climbing a wall of worry.

(*) The max pain price points to a theoretical price convergence point in which the underlying converges toward a price which would cause the greatest amount of financial loss for option traders at expiration. In options pricing theory, up to 90% of options held to maturity are expected to expire worthless which lends to the arguments for tactical options writing as a yield strategy. Needless to say, empirical evidence has been sketchy at best.

90 day outlook – Notional value, premium and net delta exposure

Notional value – most of the written options are calls and of all outstanding contracts most are pinned around 28JAN and 25MAR expirations. As stated earlier, this will dictate the price window over the coming 90 days.

Premium – puts are sought after at the moment, an undisputed sign of fear and bearish outlook among investors. More so, in fact, around the 25MAR expiration which corresponds to a 50K MPP (see above). This, despite the fact that calls are more numerous. This creates an opportunity for asymmetric bets if a short squeeze was ever to happen.

Net delta exposure – delta is the change in the option price for BTC per unit change in the value of BTC. Puts have negative delta while calls have positive delta. In conjunction with the previous two charts, what net delta is telling us is that there are more puts expiring 28JAN but the 25MAR puts are worth a helluva lot more!

Options volumes and open interest, 1 month to 15th JAN 2022

From actual transacted volumes, put strikes are clustered from the 39K to 48K price range and call strikes are clustered in the 43K to 60K range. Looking at open interest, >95% of options are out-of-the-money. The region of OI overlap is between 40K and 48K. More work is required by the bull thesis to break through and hold 48K as a first leg to structurally shift positioning and provide price support for higher ground.

Gamma is the percentage change in Delta per percentage change in BTC. Calls have positive gamma while puts have negative gamma. Roughly speaking, gamma reflects a change in the positioning of the market as to the rate at which investors are moving toward net long or net short. From the left chart, the bulk of the distribution showing the tussle between calls and puts is situated between 40K and 50K. The Buy/Sell volumes across all expirations tell the same story. Hence, the bull-bear battleground over the near term is somewhere between a lower bound of 38K-40K and an upper bound of 48K-50K.

Network Value to Transactions Ratio (NVT)

Developed by Willy Woo, the NVT model is simply the market cap of BTC divided by the transaction volume in USD across the network over a specified period.

Long term, transaction volume grows in line with bitcoin market cap. With a rising NVT ratio, market cap growth starts to outpace utilisation of on-chain transaction volume and value settlement, implying a price premium. With a falling NVT ratio, network valuation as per market cap would be at a discount relative to on-chain activities. Fundamentally, NVT makes an utility argument for the bitcoin network in its application as a payments and value settlement network. Technically, it behaves somewhat like a moving average series in that it lags market price.

What we notice from the chart above is that whenever market price crosses NVT and vice versa, that tends to mark a turning point for the prevailing trend. However, we should also take care with that assertion in that:

  1. Causally, it relies on the utility argument holding; and
  2. We have to be wary of false signals when the cross takes place near the top of an NVT cycle (red arrows in the chart)

Both timing and position-sizing are important for risk management. The cross we see in JAN 2022 above takes place at an NVT top which, historically, signalled more pain to come before a genuine bullish turnaround. Investors who bought in on NVT uptrend cross in FEB 2018 had to wait another 16 months before price recovered to those levels again in JUN 2019. SImilarly, following the NVT uptrend cross in SEPT 2019, it wasn’t until JUL 2020 that prices began to take off for higher ground.

Be disciplined, be vigilant

The information presented above are NOT predictions. Rather, they provide us with a clear-eyed and informed view as to where bull-bear battleground is situated and the LEVELS we need to clear for either camp to upgrade their conviction. A break below 40K and then 38K would signal BTC heading directionally lower. A break above the 48K-50K zone would lend credence to a bull thesis and a resumption toward higher ground.

Timing and position-sizing are important. It is important that we remain principled in our execution and abide by an investment thesis that is adaptive and resilient to impulsive whims. That is the smarter way to HODL!


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