There have been many ebbs and flows to the cryptocurrency market through the years. One common theme that has attracted both retail and institutional investors is the relationship and intuition that if global central bankers debase fiat currencies with ultra-easy monetary policy, there should be more upward movement of cryptocurrencies. We can see the relationship between M2 money supply year-over-year growth and the price moves in bitcoin and ether (Figure 1). Monetary policy acts with a lag, but sure enough, as M2 growth accelerated, the prices of each moved higher. Then, as M2 growth slowed down, there was downward pressure on bitcoin and ether.

Taking this a step further, as more rate hikes this year are priced into the SOFR futures curve and as this easy policy is removed, prices in Cryptocurrency futures have moved lower as well. Seen as ‘long duration’ assets given there is little near-term cash flow and most fundamental value is ascribed to future growth, cryptocurrencies should not be expected to do well in an era of rising rates, the same way longer-dated fixed income, credit instruments or high-growth tech stocks should not, either.

Based on the hawkish speech by FOMC Chairman Powell at Jackson Hole, we should expect even more pressure for the Fed Funds Target Rate to move higher. This has had an inverse correlation with money supply growth. Thus, we should expect money supply growth to continue to slow, putting even more pressure on cryptocurrencies.

However, while there are macro drivers to the cryptocurrency universe, there are also idiosyncratic drivers. Over the last 4-6 weeks, a big potential catalyst is the Ethereum Merge. This is when the proof of work and proof of stake blockchains are merged and the ecosystem is moved entirely onto a proof of stake (PoS) blockchain. Seen as the answer to both environmental concerns along with transaction speed concerns, it is a positive catalyst impacting ether but not impacting bitcoin. If anything, it might be seen as a negative catalyst for Bitcoin on the argument that more development will migrate to the Ethereum network.

Prior to this catalyst, in a risk-off tape for all asset markets, we had seen an investor preference for bitcoin over ether, price action that is not uncommon over the last five years. As ‘digital gold’, bitcoin sees relative inflows in times of market stress.  However, over the last month or so, ether has outperformed bitcoin as we can see in the relative value chart of the two futures prices. Prices have moved from two standard deviations cheap at the June lows to two standard deviations expensive as of the middle of August.

Looking at the futures curve, we can see the market starting to price in this catalyst. Looking at the evolution of the futures term structure of ether, it moves from a standard upward sloping contango market, which we should expect to see in general, to a market where there is a dip in the futures around the Merge catalyst. One argument for this might be that investors have all gotten long cash in anticipation of this catalyst and some are looking to ‘lock-in’ the gains by selling the future just after the expected merge, sometime between September 15-16. With the large upward move in spot, there is pressure to sell post the event even below the current price to build the cash and carry arbitrage. This suggests investors potentially see a ‘buy the rumor, sell the news’ or ‘travel and arrive’ type of reaction to this catalyst. Another explanation could be that holders of ETH cash will get the PoW + PoS post the merge, while the futures will only be PoS. This means long cash & short futures locks in PoW ETH for free. One final interpretation may be that there is a small possibility of a failure of the merge and selling futures struck after the merge while staying long cash is a hedged position. Regardless of the rationale, we have seen the futures term structure flatten and then create a dip around the catalyst.

This is happening at a time when the front month futures contract itself, as well as the cash price, are looking technically weak. With hawkish central bank rhetoric from both the Fed and ECB at Jackson Hole, riskier assets and long duration assets have seen negative price action. Looking at the daily Ichimoku cloud, Ether futures ran into resistance and stalled around 2,000, exactly as the cloud would predict. We are now seeing the MACD and RSI roll over, contributing to weakness in the front month.

Turning now to the options implied volatility term structure, we can see a relatively flat term structure at a very high volatility in excess of 100, between September and January of 2023. As a reminder, an annualized implied volatility of 100 implies a daily move of 6.25% every day over the life of the option until that expiration. That is quite a lofty expectation especially as we look further out.

However, it is not enough to look at an implied volatility level and say whether that number is high or low in a vacuum. It’s important is to compare the level of implied volatility to the actual movement of the futures - the realized volatility - to gather how much of an insurance premium is being priced into the security. For instance, when you look on the left side of the graph (Figure 8), in June of this year, we had implied volatility for the generic 30-day options at 105 as they are now. However, at that time, the realized volatility was 130 or more. Thus, the implied volatility represented a relative bargain as an investor could buy the options, delta hedge, and make money. (Refer back to our delta hedging with Micro Bitcoin options piece earlier this year.) Right now, given roughly the same implied volatility of 105, we see a realized or historical volatility in the low to mid 80s, suggesting the implied options market have a reasonable amount of insurance premium embedded in them.

Comparing options within the same maturity but at different strikes, let’s look at the 25-delta risk reversal to see if there is a preference for upside or downside strikes. There is relative preference for calls over puts (represented here as the calls being at a vol discount) moving consistently with the futures price. As futures moved lower, there was more of a preference for puts. As futures moved back higher, the bias toward calls came back.  However, those options still traded at a volatility discount.

Looking just on the call side of the ledger, we see the kurtosis, or the premium one would pay for a lower delta (10 delta) option over a higher delta (30 delta) option has also ebbed with the futures price.

The same is true for the kurtosis of the puts. In both cases, the kurtosis on the put side is near the flattest level of the last 3 months.

Finally, I want to consider volume and open interest. The bulk of the open interest is residing in the regular September expiration contract. Interesting to see the ratio of put volume to call volume is markedly higher in the contract right when the merge is expected to happen.  This is also where the skew, or the implied volatility of calls less puts, is the most severe.

Pulling this all together, there is indecision in the market right now. The overall cryptocurrency asset class is struggling from the weight of central banks removing liquidity which effects the longest duration assets. Technically, we can see this in the breakdown of the ether daily chart. In addition, on a relative basis, ether looks extended versus bitcoin and is pulling back. however, there is potentially a major catalyst for Ether in the upcoming weeks. The anticipation and discussion of the catalyst took ether to relative high prices, doubling off the lows. perhaps the pressure on ether now is a function of those who are long cash hedging their positions in the futures markets. We can see this in the risk reversal or skew in implied volatility where there is a premium for puts over calls, suggesting end-user demand is to hedge longs.

Looking to the options market, implied volatility is high in absolute terms – 105% annualized implied volatility that needs a 6.25% move PER DAY to breakeven – as well as in relative terms vis-a-vis the historical volatility – 105% vs. about 85% realized volatility so a meaningful insurance premium we haven’t seen this year. Investors are not focusing their demand for options too far out of the money, and so the kurtosis has come down a bit but still demands a higher volatility for the wings. With so many moving parts, in my opinion, the possibility of the Merge becoming a non-event along the lines of Y2K is increased. Traders are hedged and the expected movement is high. For me, this is the type of event where I want to sell the implied volatility or sell the expectation of a major move in either direction, because there are so many cross-currents that can negate each other. However, it is risky to sell a straddle or a strangle on an asset that is moving in excess of 80% volatility. One could consider a condor, where the trader sells the 1400-1500 strangle and buys the 1250-1650 strangle as protection to stop themselves out if futures do have a big move. Using mid prices, the position can take in 114 points to execute this transaction. The risk if we move below 1250 or above 1650 at expiration is 36 points (150 strike difference less 114 in premium). If we stay between 1400-1500 a trader takes in 114 so the reward to risk is about 3.2 to 1 (114/36) at the peak profitability. A condor is a great way for traders to sell volatility while still having a defined risk to the position. With a good amount of open interest in the September expiration, strikes can serve as magnets to draw futures prices toward them at expiration. This may benefit the seller of volatility.

The Ethereum Merge has been discussed for almost eight years. It is a catalyst, one of the few positive catalysts in the market perhaps, but it is a very well-known catalyst. Traders appear to have set-up this trade with long cash plus short futures or long cash hedge with risk reversals. There are reasons to think despite the positive catalyst, there are negative headwinds to Ether on a relative basis, and cryptocurrency broadly speaking. This can be an opportune time to sell implied volatility, and a condor spread is a defined risk vs. reward way to do so.

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