In our final topic of this four-part series, we discuss our thoughts on how to invest in Bitcoin (or cryptocurrency).
At present, most investors appear to be holding/trading Bitcoin to “get rich,” to the tune of ~$1 trillion in market capitalization. We certainly have no qualms with those pursuing great reward at the assumption of great risk. However, we prefer to pursue strategies that seek to compound capital efficiently over longer periods of time in what we call “stay rich” strategies.
To this end, we think a successful Bitcoin investment strategy should accomplish a few key objectives.
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* CME Bitcoin options are European style which prohibits early assignment of Bitcoin futures.
Setting aside any fundamental and/or technical analysis, we believe the combination of Bitcoin’s volatility and seemingly uncorrelated return profile (figure 1) offers a potentially attractive investment opportunity for investors to generate a unique return stream by attempting to harvest volatility as part of a diversified portfolio. That said, our recommendation is to do so through a hedged format.
Figure 1. Nothing Compares
Source: Bloomberg LP. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
The explicit catalyst for our thinking was the introduction of Bitcoin futures (at five Bitcoins per contract or ~$275,000) and options by CME Group in 2020; more recently, on May 3, 2021, CME Group launched Micro Bitcoin futures, which trade in units of 1/10th of a Bitcoin (roughly $5,400 per contract). While overall volumes and open interest levels vary, Bitcoin futures have experienced exponential growth, listed option markets appear to be well quoted despite relatively limited activity, and over-the-counter (off-shore) markets like Deribit and FTX have exhibited substantial volumes and open interest levels. Figure 2 plots the growth of options and futures open interest on a some of the larger platforms.
Figure 2. Bitcoin Futures and Options Open Interest
January 2019 to December 2021, USD millions notional
Source: Bloomberg LP. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
We believe, with a functioning futures market supporting it, the Bitcoin option market is accessible to investors. And, to adopt the old Gold Rush wisdom, if Bitcoin is the gold, Bitcoin derivatives could be the pickaxes and shovels.
Bitcoin Pickaxes and Shovels
Most daily Bitcoin transactions occur “off-blockchain” (“off-chain”), meaning they are never verified and posted to Bitcoin’s public distributed ledger (“on-chain”). Off-chain cryptocurrency transactions reduce/eliminate the latency and expense of verifying “on-chain” transactions, a process that takes about 10 minutes on average and currently costs about $30 per verified transaction regardless of the dollar value of the transaction for Bitcoin. While off-chain transactions may diminish Bitcoin’s coveted platform-independent status, they allow transaction volumes to be potentially unlimited.
Persistent buying and selling of a new asset class, i.e. proven liquidity, is typically required to build institutional investor confidence before they will adopt futures and options markets and enable them to supplement the established cash market.
We believe cryptocurrency may have a lower hurdle to clear than most new asset classes for investor adoption of futures and options. Given the relative complexity of Bitcoin custody and trade verification on its blockchain, derivatives markets may grow rapidly as more efficient sources of exposures. We anticipate that many investors will appreciate standardized, exchange-traded, centrally cleared derivatives, such as CME Group products, held at secure, crypto-friendly custodians/prime brokers, as their off-chain access to Bitcoin.
Uncorrelated Premiums
Given our decade of experience with developing successful systematic options strategies on a variety of volatile index exposures, we are confident that there may be similar success to be found with Bitcoin. With 10 years of price history, shown in figure 3, the risk of Bitcoin is well observed, with both the left and the right “tails” of its return distribution adequately “feared” by market participants.
Figure 3. Bitcoin’s Fat Tails—Left and Right
Bitcoin & S&P 500 Index 60-Day Return Distributions, November 2010 to June 2021
Source: Bloomberg LP. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
In our basic economic framework, an implied volatility premium is nothing more than a profit margin required to incentivize investors to underwrite risk. In a competitive market like S&P 500 Index options, the implied volatility premium is consistently positive but not exceptionally high. In the case of Bitcoin, volatility levels are exceptionally high and relatively unstable, and investors must consider not only traditional risks, such as regulation and investor sentiment, but also unique risks such as “forks” in a cryptocurrency’s protocol, wallet security, “51% attacks” and selfish or deviant miners.
Over their relatively short 18-month history, options on Bitcoin futures have offered relatively high implied volatility premiums, averaging between six and 10 implied volatility points—significantly higher than standard equity implied volatility premiums (figure 4). Further, like other commodity option markets, Bitcoin options have skew present in both the right and left tails of their implied volatility smiles. While volatility levels may decline as Bitcoin becomes more liquid and institutionalized, we expect the need to warehouse risk, and therefore the demand for downside protection, to increase, which would result in Bitcoin options carrying a relatively high implied volatility premium for a fairly long period of time.
What excites us is the prospect that, as they evolve, digital assets, led by Bitcoin, could provide a rich source of uncorrelated premiums for years to come.
Figure 4. Elevated Premiums From Bitcoin Put-Writing
Bitcoin and S&P 500 30-day at-the-money option implied volatility, January 13, 2020 – June 30, 2021
Estimated Bitcoin option implied volatility premium, January 13, 2020 – June 30, 2021
Source: Bloomberg LP. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
End of Chain
Having researched the option implied volatility premiums of many exposures, we are confident in suggesting that there are only a handful of persistent volatility premiums for investors to harvest at a meaningful profit over the long term—contrary to the seemingly limitless permutations of volatility-based strategies. In our opinion, the universe of premiums is limited due to the interconnectedness of the global financial system. Basically, there are only so many exposures (equities, bonds, commodities, volatility) with tradable options and implied volatilities across these universes, and, moreover, they tend to be highly correlated during periods of stress.
Enter Bitcoin. With its unique set of ‘digital’ risks generating an uncorrelated, extremely volatile, fat-tailed return profile, its relatively developed option markets (listed and over-the-counter), Bitcoin may offer a rare, new and unique implied volatility premium. The very uncertainties that cause some speculators to make “get rich” bets on the cryptocurrency lottery and others to avoid it altogether are precisely the characteristics that have the potential to generate steady, compounding premium income for options investors.
Our near-term assumption is that investors will continue to use Bitcoin as a speculative exposure to rapidly growing cryptocurrency markets based on their own personal justifications. Ultimately, we believe Bitcoin will have to prove out its portfolio diversification benefits, with volatility-based Bitcoin strategy exposures providing additional diversification benefits, to be adopted as a strategic allocation in investor portfolios and to have additional financial product layers built around it. We do believe that’s where we are headed. Regardless, we aren’t going to let the uncertain destiny of Bitcoin prohibit us from trying to monetize its unparalleled levels of volatility.
