One of the exciting developments from last week was the U.S. Securities and Exchange Commission’s (SEC) nod for approval and listing of physically settled options tied to BlackRock’s spot bitcoin (BTC) ETF, the iShares Bitcoin Trust (IBIT).
There is consensus that the IBIT options, which still needs to be greenlighted by the Options Clearing Corporation (OCC) and the Commodity Futures Trading Commission (CFTC), will further help draw institutions to the crypto market. The crypto community, however, seems split on how it would affect the bitcoin market volatility.
Per Bitwise Asset Management, gamma squeeze, a rapid price rally catalyzed by options market dynamics, could become a feature of the bitcoin market following the debut of IBIT options.
Gamma squeeze
To understand the gamma squeeze, readers must know how options work. Options are derivatives that allow the buyer the right to buy or sell the underlying asset at a predetermined price on or before a specific date. A call option gives the right to buy and represents a bullish bet on the market, while a put option represents a bearish bet.
Options gamma is a metric that gauges how an option’s delta, or the sensitivity of an option’s price to movements in the underlying asset, changes for every $1 move in the underlying asset’s price.
When investors buy a lot of call options, anticipating a price rally, market makers, who are mandated to maintain a net market-neutral exposure, end up on the other side of the trade, holding large amounts of short call positions, often called short gamma exposure. As such, they purchase the underlying asset as the market rallies because they are obligated to deliver the underlying asset to the call option buyer.
The hedging activity puts upward pressure on the spot price, causing a sharp rally, like the one in shares of American video game retailer GameStop (GME) in 2021.
Per Jeff Park, head of alpha strategies and portfolio manager at Bitwise Asset Management, IBIT options, offering regulated leverage on a supply-constrained BTC, will draw solid institutional demand for calls, setting the stage for a gamma squeeze.
“Bitcoin options have negative vanna: as spot goes up, so does volatility, meaning delta increases even faster. When dealers [market makers] who are short gamma hedge this (gamma squeeze), bitcoin’s case becomes explosively recursive. More upside leads to even more upside as dealers are forced to keep buying at higher prices. A negative vanna gamma squeeze acts like a refueling rocket,” Park said on X.
Park explained that IBIT options will eliminate the “jump-to-default (JTD) risk” that has kept institutions at bay, allowing bitcoin synthetic notional exposure to grow exponentially. JTD refers to the risk of an issue or counterpart defaulting suddenly before the market can adjust for the increased risk.
He expects a strong investor bias for longer-duration out-of-the-money (higher strike) calls once the options go live.
“With bitcoin options, investors can now make duration-based portfolio allocation bets, especially for long-term horizons. There’s a good chance that owning long-dated OTM calls as premium spend will give investors more bang for their buck than a fully-collateralized position that could drop by 80% over the same period,” Park said.
During an interview with CoinDesk, Bitwise Asset Management’s head of research Europe, André Dragosch, voiced a similar opinion, saying, “The consequence of this would be a price spike similar to what we have seen with GME, which is akin to a “short squeeze” in futures.”
Dragosch added that the upside volatility from the so-called gamma squeeze could be more pronounced due to the fact that bitcoin’s supply is capped at 21 million BTC.
The other side of the story
Per Greg Magadini, director of derivatives at Amberdata, the gamma squeeze could be seen if a perfect bullish storm, characterized by Republican candidate Donald Trump’s victory in the upcoming U.S. elections and Fed rate cuts, grips markets. However, over the long-run, increased institutional participation via the ETF and ETF options is likely to dampen volatility.
“Institutional flows, in particular, are counter-cyclical. Portfolio managers tend to trim exposure through quarterly rebalancing, selling appreciating assets when bitcoin rallies too much,” Magadini said in the weekly newsletter shared with CoinDesk.
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Bitcoin’s realized or historical volatility has been trending lower since the Chicago Mercantile Exchange listed bitcoin futures in December 2017, opening doors for traditional institutions to take exposure to the cryptocurrency.
Besides, institutional flows via IBIT options could temper Bitcoin’s upside-implied or expected volatility, according to Magadini.
“Another well-known effect of these flows is their impact on implied volatility. Institutions buy protective puts and sell covered calls, which dampens upside implied volatility,” Magadini noted.
Implied volatility, or investors’ expectations for the degree of price turbulence over a specific period, is influenced by demand for options. Upside implied volatility picks up when investors buy calls and vice versa.
Sophisticated investors use the covered call strategy to generate additional income on top of their ETF holdings, as observed in the gold market. The strategy involves selling a higher strike ETF call option and pocketing the premium (option’s price) while holding a long position in the ETF. The short leg puts downward pressure on the implied volatility.
Crypto traders have been setting up covered calls through Deribit’s bitcoin options, leading to lower implied volatility over the past few years.
“As institutional ownership grows, their behavior has a greater impact. This means that, ultimately, institutional adoption leads to lower volatility in Bitcoin. This is merely a continuation of the clear structural decline in Bitcoin’s volatility,” Magadini summed up.
