How Options Traders Are Profit From DeFi Gyrations
Cryptocurrency options traders are cashing in on the recent gyrations in the decentralized finance (DeFi) market by selling volatility ahead of key events.
According to data from crypto analytics platform Skew, DeFi options vaults put downward pressure on implied volatility every Friday, creating a window of opportunity for savvy traders to short-sell volatility ahead of the event.
Options are hedging instruments that give the holder the right, but not the obligation, to buy or sell an asset at a set price within a certain time frame. For example, a trader who holds a call option on bitcoin with a strike price of $50,000 and expires in May will be able to buy one BTC for $50,000 on or before May expiry. If the price of BTC is below $50,000 at that time, the option will expire worthlessly and the trader will lose the premium paid to purchase the option.
In the past, the crypto market was dominated by directional trend traders betting on bullish or bearish prices. 2021 ushered in a different brand of traders, known within the industry as volatility traders. These volatility traders bet on a rise or drop in implied or expected price volatility over a specific period.
These entities are increasingly employing strategies to profit from public market information. One of the most important is the weekly automated options strategies that are auctioned by decentralized option vaults (DOVs) every Friday. Every Friday at 11:00 coordinated universal time (7 a.m. ET), the option vaults allow anyone willing to deposit their coins there to earn double-digit annualized returns.
What’s more, these vaults don’t just hold ether (ETH) and bitcoin (BTC), but also a variety of ERC-20 tokens, including those issued by popular protocols such as MakerDAO, Synthetix, and yearn.
These options vaults sell higher strike, or out-of-the-money (OTM) calls and lower strike OTM puts, driving implied volatility lower every Friday at the time of auction. This trading strategy is eerily similar to setting a short position in the spot or futures market to benefit from an expected decline in prices.
On Friday, many of these traders were caught off-guard when Bitcoin’s price unexpectedly dropped 10% in the span of an hour. The massive sell-off caused implied volatility (IV) to spike as high as 140%, its highest level since mid-March.
The DeFi markets have been one of the main drivers of Bitcoin’s price rally in recent months. However, the sector has come under intense selling pressure in the past week as investors have taken profits and rotated their capital into other asset classes.
The sudden drop in Bitcoin’s price caught many options traders off-guard and left them scrambling to cover their losses.
According to Robbie Liu, senior researcher at Babel Finance, “The strategy has been quite popular. It was very profitable initially, but with time, more and more traders are doing this. So, profitability has been diminishing quickly.”
Liu is referring to the so-called “gamma squeeze” trade that has become increasingly popular among options traders in recent months. The trade involves selling options with a high gamma, or sensitivity to changes in the underlying asset’s price, and buying options with a low gamma.
The trade is generally profitable if the underlying asset’s price remains relatively stable. But if the asset’s price starts gyrating wildly, as has been the case with many cryptocurrencies in recent days, the trade can quickly turn against the trader.