Calculated Risk

Bitcoin Options Would Tame This Beast

Price discovery would be a lot quicker if extreme views were squeezed out of the market.
Photographer: Chris Ratcliffe/Bloomberg
At Closing, April 23th
61.20 USD
At Closing, April 23th
27.60 USD

The seminal financial event of this year, the current decade, and possibly our generation is here: Futures trading in bitcoin has begun.

But the derivative that would really damp the current crypto frenzy and make digital tokens a speculator-friendly -- if not investment-worthy -- commodity, currency, tulip, or whatever, isn't futures. It's options.

Curb Your Enthusiasm

Options could supplement futures contracts in damping irrational exuberance for bitcoin

Source: Bloomberg

It's hard to see how even existing futures trading rules can deal with something as volatile as bitcoin.

Cboe Global Markets Inc. began offering them on Sunday, and soon they'll be available on CME Group Inc. Brokers including E*Trade Financial Corp., TD Ameritrade Holding Corp. and Ally Financial Inc. will probably follow suit. But as Lily Katz of Bloomberg News notes, if Thursday's price movements were to be mirrored in futures contracts, trading would have to be paused or suspended a number of times throughout the day.

The hope is this chaotic state of affairs will change. Once it's possible for large pools of institutional liquidity to bet against an irrationally high (or low) futures price in relation to the spot, the latter will also steady.

To speed up stabilization, though, you need options.

A one-month futures price of, say, $16,000 only tells you that if you sell a bitcoin when it's going for $16,704, and buy a futures contract expiring in a month, you're effectively earning a bitcoin rate of interest of 57 percent, annualized.

Whether investors judge that to be too high or too low given all the other interest rates in the economy, including, most importantly, the U.S. dollar one of 1.52 percent, will see spot and futures prices adjust accordingly. That discovery would be a lot quicker if extreme views -- those who think bitcoin will be $100,000 in a month and those who bet it'll be $1,000 -- get squeezed out of the market. What futures prices won't tell us is the dispersion of expectations and their probabilities.

Pelham Smithers Associates and Albert Maass have done a useful analysis of bitcoin options on futures contracts that currently trade on Deribit, a European derivatives bourse for the digital currency. They constructed an at-the-money "straddle" around a strike price of $12,000 on Dec. 5 by buying two bitcoin put options for that amount and one call. The structure would only make money if the March futures price went above $18,000 in a month (i.e., by early January), or fell to $9,000 or less.

A Wicked Grin

An at-the-money straddle on bitcoin options on Deribit on Dec. 5 was profitable only if the price of the futures contract rose by at least 50 percent, or fell by 25 percent, in a month

Source: Pelham Smithers, Smartkarma

Note: Possible prices on Jan. 2, 2018 of March bitcoin futures contract.

Bitcoin options, in their current form, only reward expectations of abnormality: a price gain of 50 percent or more, or an erosion of at least 25 percent, in one month. As the analysts noted, "options are so rich, you need a big move up or down in bitcoin to justify their price."  A straddle on the British pound, by contrast, would make money if the exchange rate moved by just 2 percent either side.

Put another way, extreme views are ruling bitcoin. The only antidote is to have a mainstream venue like CME or Cboe offer options, so that irrational exuberance (or pessimism) is edged out. Exchanges, however, are already getting flak, including from some of the world's biggest derivative brokers, for rushing the contracts to market without thinking through the risks.

For the foreseeable future, bitcoin options look set to remain a boutique parlor game, where cranks will dominate. That's a missed opportunity to tame this beast.

(Corrects ninth paragraph to say straddle consisted of two puts and one call.)
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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    Andy Mukherjee in Hong Kong at

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