BTC Term Structure Opportunities

• Samneet Chepal

Note: This piece is only for educational purposes and does not constitute investment advice. Views are my own and do not express the opinions of LedgerPrime. A special thanks to Nikhil Talwar for encouraging me to explore this trade and explaining the mechanics of the IV term structure.

Every now and then the BTC options term structure will exhibit strange behavior. Before we start to investigate potential trading opportunities in the term structure there are a few key points to understand:

• The term structure is used by traders to understand how volatility is priced across different option expiries. Each point on the term structure represents the implied volatility (IV) for an option near the current price of BTC (ATM option). Recall IV is the market’s expectation of future volatility over the option’s maturity.

• Shorter dated options generally have more volatile IV values relative to longer-dated options. For example, if BTC were to decline by 10% within a single day this would likely impact all IVs across the term structure. In this case, it’s reasonable to expect the weekly option IV to jump much higher than the yearly option IV. The shorter-dated option IV is more sensitive because there’s less time for volatility to revert back its average value. Conversely, a large spike in short-term volatility will likely mean-revert over a one-year period which is why the longer-dated option IV is less sensitive to these impacts.

• The term structure usually rotates between the two states of contango and backwardation.

• Contango is when the IV term structure is upward sloping and is what we generally expect in normal market conditions. It suggests the market is expecting higher volatility across future maturities.

• Backwardation occurs when the IV term structure is downward sloping. It is common to see the term structure in backwardation after large sell-offs because this causes shorter-dated IV to rise higher than longer-dated IV. Although IV is priced higher in the short-term, periods of backwardation suggest volatility will mean-revert and be lower in the future.

With this base level understanding, we can now explore some interesting behavior that occurred in the BTC term structure on April 28, 2021. While the IVs between shorter-dated expiries on the term structure can vary quite a bit, for the reasons mentioned above, longer-dated (ie: 30+ day) options should have less of a spread between neighboring maturities.

Interestingly, the spread of the ATM option IV between the May 28 and June 25 maturities was nearly 6 volatility points. Historically, the ATM spreads between the one and two-month maturities ranged anywhere from 2 to 3 volatility points on average. As a result, given the observed spread is nearly double the average it’s worthwhile to explore this further.

I believe this opportunity exists due to the inefficiencies of the nascent cryptocurrency options market. It’s likely the market flow is dominated by options buyers (presumably net call buyers) which caused the IV to bid up for this maturity. If we expect this spread to revert back to its historical average, we could simply buy ATM May and sell ATM June options (ie: buy cheap May IV and sell expensive June IV). This position would do well in the case BTC experiences sharp moves near maturity and/or IV falls. Let’s review the greek exposures for this trade:

- Delta: It’s likely this calendar spread will not be delta neutral at inception, therefore, we’d hedge any initial delta with futures contracts.

- Vega: Given we’re selling a longer-dated contract and buying a shorter-dated contract, at inception our trade will have negative net vega. This means any upward moves in IV will adversely impact the PNL of this trade.

- Theta: Given the shorter-dated option will have higher time decay than the longer-dated option, this calendar spread will incur unfavorable theta decay as we get closer to maturity.

- Gamma: One advantage of this trade is we’re exposed to positive gamma from the front-month option so sharp price moves will be beneficial for the trade.

Interestingly, this wide spread between the two months only lasted for a few days. The day after we posted about this opportunity on Twitter, the spread compressed down to only 3 volatility points which suggest sophisticated market-makers and hedge-funds caught onto this trade. Overall, although this opportunity existed for nearly a day, as savvier players begin trading cryptocurrency options it’s reasonable to expect much faster market reactions to these inefficiencies.