Executive summary

Veteran institutional trader Rich Excell covers options on futures centric strategies for managing price risk and capturing opportunities from volatility in bitcoin markets:

  • Why U.S. legislation may be driving a new need to hedging long bitcoin positions
  • Ways to use CME Group QuikStrike tools to help evaluate potential hedging strategies
  • How financial advisors could use put-call spreads to hedge a crypto portfolio
  • How newly arrived institutional investors can use Bitcoin options to manage market volatility that might otherwise prevent using crypto in strategies

Welcome to Excell with Options. My goal is to teach you how you might want to consider using options (and futures) in your own investment portfolios. Having worked as a market maker, investment bank trader and hedge fund portfolio manager for 30 years, I have some ideas about the many ways options can and should be used.

Options are insurance, nothing more and nothing less. We use insurance every day in our lives – auto insurance, homeowner or renter insurance, and even travel insurance. We don’t seem to struggle with understanding the concept or the pricing for those. The biggest difference with options as insurance in financial markets is that we can both buy insurance AND sell insurance; said another way, we can use options for both risk management and for income generation.

No companies advertise in the media about buying insurance from you. All companies want to sell it to you. This is because, often, insurance policies aren’t claimed, or in options terminology, expire without value. If we don’t have an accident for a year, do we decry that our auto insurance went out worthless? No, we are happy we had it because we could drive worry free for the year.

Similarly, options insurance may protect us from a portfolio drawdown, but more importantly, may free us to make better portfolio decisions. To the extent we can understand the risk and return trade-off, and sell insurance, it can help us add income to our portfolios. Income is hard to come by in a zero-interest rate world.

Every other week, I will try to find a part of the market where some interesting options ideas might line up. I am NOT going to, nor intend to, give investment advice. Speak to a financial advisor for that. What I will do is try to lay out some scenarios of what could happen, and how one might use options to reflect that view.

Since 2021 was the year of cryptocurrencies, I thought there might be no better asset class to start with than this. CME Group offers financially settled Bitcoin futures contracts to accommodate both institutional and sophisticated, active individual traders. For the options market, right now we have options on Bitcoin futures to consider. Early in 2022, there are several potential catalysts that may affect the digital asset space – government regulation, capital gains tax hikes, continued struggles in emerging markets, etc. Let’s look at some scenarios that may happen and how investors in different buckets might use the options market to reflect a view.

Financial advisor – portfolio hedge using options on Bitcoin futures

Regardless of your long-term view on cryptocurrencies, there is no denying that the last eight months have been a struggle. While the final tally will show bitcoin +60%, all of those gains came in January 2021. The rest of the year was a very volatile sideways pattern. While 2021 was the year of institutional adoption, it was also a year in which cryptocurrencies went mainstream. Many individuals and many financial advisors finally found a way to get crypto into their portfolios.

Consider this scenario then: In the Build Back Better bill before Congress – because one side of the party does not want to give up on some pet projects getting funded, but another side of the party is very worried about the overall cost of the bill – there is a possibility of capital gains taxes moving even higher than consensus expects. In addition, there is some talk about taxes on unrealized capital gains, which is presumably targeted toward billionaire venture capital and private equity partners, but could impact many people in this group of investors, because the IRS treats cryptocurrency as property. It can become even more painful if unrealized gains (those where you haven’t sold yet) are taxed. This group of investors may want to hedge their cryptocurrency portfolio.

CME Group has a terrific tool from QuikStrike called Strategy Simulator. This tool allows us to look at the price of various hedging strategies. We can look at the price now and through time. We can compare the price of one strategy to another. Traditionally when we think of hedging, we immediately think of buying a put. After all, a put is the classic form of insurance. However, what most investors see is the premium outlay. This is seen as a potential drag on performance. To lower the cost, investors tend to look further out of the money to lower the premium price. This makes the hedge even less effective.

Another way to consider hedging a long portfolio, of say bitcoin, is to look at what the options prices are showing you. If we analyze bitcoin, two things stand out:

  1. The implied volatility for bitcoin is quite high, in the 70s or 80s. I am not saying this is not justified by the price movement, but it does make option prices higher.
  2. The price of call options, especially well out of the money, tend to be higher than put prices. This is called positive skew, which is contrary to what is typically seen in equities markets, which usually have negative skew. Positive skew is more typically seen in commodities products such as corn or wheat. 

Hedgers will want to take these various factors into account in developing a strategy. When I say hedgers, the assumption here is that the investor is long bitcoin and not a portfolio of various cryptocurrencies. One would not typically use this structure without an underlying position.

For example, rather than buying a deep out of the money put option, hedgers may want to consider a put-spread collar. The put-spread collar enables a hedger to buy a put strike much closer to at the money, so the hedge starts sooner. It also involves selling a second option to reduce the cost. This structure differs from a traditional collar strategy, where an investor sells an out of the money call option and uses the proceeds to buy a put option. While this strategy can be useful, the drawback is that the strike of the put options is typically far out of the money. By using a put spread instead of a put in this collar, the initial strike where the hedge begins can be struck much closer.

Of course, as we know in economics, there is no such thing as a free lunch. The biggest downside risk is that the hedge ends at some point. The protection of the strategy ends where the downside put is sold. In the case of bitcoin, this means that an investor must be willing to get long again at some point. For most bitcoin investors, this is typically not a difficult decision. Maybe harder is the other leg of the strategy, which is selling a bitcoin call. Doing this, a hedger is taking advantage of the high implied volatility to sell an extra option, which allows the put spread strikes to be even more favorable.

As you can see from the QuikStrike spread builder below, by selling a 59,000 call, the hedger can afford to buy a 43,000-34,000 put spread, giving protection on a move down less than 10%, with the risk that the hedger must get long bitcoin again down 28% (34,000) and has their long position effectively called away up 25% (59,000).

Said another way, your portfolio is hedged between the strikes of the put spread (43K and 34K), below which it is not. To pay for this hedge, the investor is willing to give up some upside of the underlying (above 59K) so the portfolio does not have a drag to it. The investor is taking advantage of the higher relative implied volatility for bitcoin calls and uses that premium to move the strikes of the hedge to a higher level.

Figure 2: Analyzing potential option strategies using the QuikStrike Strategy Simulator

Institutional investor – relative value opportunity + hedge

Institutional investors come to the various markets with many of the same biases that all investors have, but also with investment mandates or investor policy statements that require them to behave in certain ways. There is much bally-hoo about the arrival of institutional investors in cryptocurrencies this year. However, the volatility in the asset class is a very real concern. This volatility will limit the amount an institutional investor can put in the asset class because it may be worried about drawdowns (and have limits as such) or have its capital allocated using value-at-risk measurements (common in hedge funds), which penalizes securities with higher volatility. However, this is why hedges exist, because much like auto insurance allows the driver to bear less risk throughout the year, portfolio insurance allows the investor to not be forced into trades during drawdowns, or even to add more portfolio leverage because the value at risk could be lower.

Another concern, however, much like above, is the cost of the insurance and how this can be a drag on performance, such that the fund may lag its benchmark. Yes, one could choose to do a collar or risk reversal, selling a call to buy a put. However, with more tools at their disposal, institutional investors can also be more creative.

The goal with options is to buy the protection you want and sell the protection you don’t need or you think is overpriced. For an institutional investor, we will look not only within a security’s option expiration, but across the expirations and even across assets.

For this scenario, I suggest that an institutional investor may be still looking to accumulate more of a cryptocurrency position over time. However, this investor also knows of the potential risks this quarter. Institutional investors will have a portfolio of assets, from cryptocurrencies to equities.

Institutional investors ideally like to find uncorrelated streams of alpha in their portfolio. But the reality is, especially in down markets, that assets in the portfolio are more correlated than they would like. For instance, if we consider bitcoin and the Nasdaq-100 Index, these assets, when using a log value regression, have a correlation of 90% and an R^2 of 80% over the last five years:

Figure 3: Examining the correlation of Nasdaq-100 and bitcoin (as of 1/3/22)

While not ideal, we can take this correlation into account when developing a hedge. We know that bitcoin volatility tends to be much higher than other asset classes. We also know that investors in this asset are more willing to buy the dip. We can utilize both in developing a hedge. A large portion of many investors portfolios are the mega cap tech stocks. This is the real risk to hedge.

Pulling this all together, we can look to sell 1 BTC March 35,000 put and take in 1855 in premium. We use this premium to buy 1.3 NQ March 15,500 puts.  We are selling a put that is 26% out of the money on a 78 volatility. We are buying multiples of a put that is only 5% out of the money on a 24 volatility and 354 in premium. BTC options have a multiplier of 5 and NQ options have a multiplier of $20.

We can see above that these assets are correlated. In a correlated risk-off event, our protection kicks in very soon and with leverage. The risk is that the price of bitcoin falls and NDX does not. The ratio of these two assets is near the all-time low at 0.34, having been in a range of 0.21–2.1 over the last three years. We are getting long this ratio at 0.44 (15,500/35,000). If assets sell off but this ratio falls lower, we are at risk. Even if both assets move higher, since it is premium neutral (actually a small credit), we will see no drag on the portfolio. Yes, this type of idea introduces a number of other risks:

  1. The correlation between bitcoin and Nasdaq may change.
  2. There is more volatility of volatility in bitcoin than in Nasdaq.
  3. News can occur that affects one asset class more than the other.

However, for an institutional investor that prefers and is long both cryptocurrencies and high growth technology stocks (which presumably is not a stretch given the performance over the last year), there is a risk of a highly correlated market drawdown that affects both investments. This idea can help to reduce the overall cost of a portfolio hedge by taking advantage of the opportunity the market gives.

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