In the above chart, we can see this in the volume and open interest chart for Bitcoin futures from CME Group. I can see the higher and higher peaks in volume around the expiration months but also, most importantly, we can see the slow and steady progression of open interest. The suggests to me that traders are getting more comfortable with the futures market, whether used for hedging purposes or for tactical directional trading. The patterns suggest we may continue to see higher highs in volume and open interest as we move into 2024a new year.

Another place I can see that enthusiasm is returning to the Ccryptocurrency markets is by looking at the discount to net asset value for the Grayscale products. The bBitcoin discount is on the left and the eEther discount is on the right. Both discounts peaked last fall at the time of the FTX bankruptcy and the peak of the crypto winter at more than 50% discount. It took some time for these discounts to start to narrow, but over the last two months, both have narrowed sharply to the low double digits. While it is not uncommon for a closed- end fund to have a discount of approximately 10%, if these funds are able to convert into spot ETFs, there still may be scope for this to fully collapse. While I am not making a comment on where these discounts should end up, the closing of the discount from more than 50% to about 11% tells me enthusiasm is returning to crypto.

Another way one may discern this investor enthusiasm is by plotting the market capitalization for crypto. On the left is the market capitalization for all coins, and while it is well off its highs from 2021, there has been a steady march higher all year long. The graph on the right excludes Bitcoin, Ether, Binance Coin, Ripple, and the stable coins. This is my proxy for the alt coins. We can see an even steeper climb in the market capitalization of these products. I think of this as the riskier asset space within cryptocurrencies and to see renewed interest in these coins suggests traders are really warming to the story. That being said, there may be more room to run as we are still well off the highs on both accounts.

If I look at the Commitment of Traders report for Bitcoin futures, I can see that the net short position is the highest it has been in two years. These traders, who were the longest in two years back at the turn of the calendar into 2023, at the coldest part of the crypto winter, are now starting to sour on the market just as it seems to be getting the all-clear signs.

Perhaps the reason the levered traders are short is that the RSI for the Bitcoin futures is the most overbought we have seen for much more than a year. On the one hand, I can see the moving averages turning higher and showing a bullish upward pattern. However, in the bottom panel, I see that in the near-term, prices may be stretched and set for a pullback in the short run. While many may not worry about this near-term risk as they may be long-term holders, for institutions who are managing a portfolio that is marked to market, this is an important consideration when year-end bonuses are on the line.

The weekly chart still looks bullish to me. I can see on the top panel that the futures pulled back to the support levels that were the resistance levels back in 2019 and 2020. Past resistance proved to be support. Using a Fibonacci retracement chart, I have identified with a colored rectangle the area that futures might target over the medium term, in the 42K to 46K range. While the futures are just broaching overbought on a weekly chart (bottom panel), I can see that they were much more overbought in late 2020 and early 2021. Finally, in the middle panel you can see the growing open interest in Bitcoin futures over time. One of the core maxims of the technical trader is that price follows volume. As volumes and open interest increase with prices rising, this is a very bullish signal in the medium term, even if we may look overbought in the shorter term.

Another reason to be bullish medium term may be the catalyst of the next Bitcoin halving, which will be around April of 2024. While this is a known event, if we look back through history at previous Bitcoin halving events, prices were not always strong going into the event, but prices always rose after. Traders may see this and want to maintain their bullish long-term positioning but want to find a way to hedge out near-term noise around the end of the year.

Before I determine what type of options strategy to use, I find it’s always useful to look at the surface of implied volatility. This allows me to see how implied volatility looks across a term structure of time. It also allows me to see if there is a premium or discount for out-of-the-money options and if calls or puts are favored. As I look at the vol surface, I can see that there is a peak of implied volatility in the December through March time frame. I also see that out-of-the-money calls have a premium to the at-the-money options or to the puts. This leads me to think that if I am looking at doing an option spread around the end of the year to lean into seasonal biases and short-term overbought conditions. I want to be net short options as the implied volatility looks higher there. In addition, the out-of-the-money puts are priced at the same implied volatility as the at-the-money while out-of-the-money calls are priced higher than the at-the-money, so if I can net sell upside options, that would be the best.

Putting these thoughts together (short-term pullback in a long-term bullish view, end of year implied volatility slightly high so net seller of options, calls are at a premium), the first idea that comes to mind is that of a put-spread collar. In this structure, I buy a 36K-31K put spread and to fund this put spread, so the hedge is zero cost, I sell a 45K call. This reduces my delta in half as the delta of the put spread collar is almost 50 deltas. It net sells options as we can see from the short vega position. You can also see the implied volatility of the two options I sell is higher than the option I buy. I chose the January expiration because this will account for any movement that occurs through the end of the year. This seems to fit the bill and this might be the easiest structure for those looking for a hedge that doesn’t need to be as actively managed.

There is another idea that may fit the profit narrative a little better: adding a 1 by 2 call spread over the top of the long future position. Do I mean a call spread? Don’t I mean put spread? A ratio call spread has a negative mark-to-market on moves higher unless we are at expiration. I can see this in the expected return chart above if I look at the curved lines, which represent expected return before expiration. On the downside, a trader will make the premium one takes in from the ratio call spread. I personally do not like 1 by 2 call spreads as a directional idea unless they are combined with a long futures position. In that case I can think of the idea as a long call spread + a call overwrite for additional yield. I must be willing to have my entire position called away on a move above the highest strike. However, if I end up at that strike, I can leverage my view. What is interesting is looking at how each position carries before expiration and thinking about the ultimate goal of an options hedge, which is to provide PNL cushion against my core portfolio ideas, in this case, long Bitcoin futures.

There is another idea that may fit the profit narrative a little better: adding a 1 by 2 call spread over the top of the long future position. Do I mean a call spread? Don’t I mean put spread? A ratio call spread has a negative mark-to-market on moves higher unless we are at expiration. I can see this in the expected return chart above if I look at the curved lines, which represent expected return before expiration. On the downside, a trader will make the premium one takes in from the ratio call spread. I personally do not like 1 by 2 call spreads as a directional idea unless they are combined with a long futures position. In that case I can think of the idea as a long call spread + a call overwrite for additional yield. I must be willing to have my entire position called away on a move above the highest strike. However, if I end up at that strike, I can leverage my view. What is interesting is looking at how each position carries before expiration and thinking about the ultimate goal of an options hedge, which is to provide PNL cushion against my core portfolio ideas, in this case, long Bitcoin futures.

Now I look at two different simulations. On the top, I look at the PNL if the future price moves down slowly. Again, I can see that the PNL from both ideas is very similar and not dissimilar to the flat market. The net short options in both structures will provide the bulk of the PNL for position. What is more interesting to me is the chart on the bottom. This is the PNL for the structures if we move up quickly. I can see the put-spread collar has a negative PNL initially but this recovers as we near expiration over time. The opposite is true of the ratio call spread. The PNL of this structure moves higher but then peaks and rolls over near expiration. Thus, if I’m inclined to trade out of this position before expiration, I may be better off using the ratio call spread which generates a similar profile in two scenarios and a better profile in a third.

The options market can be a powerful tool in the toolkit for the trader that knows how to interpret and optimize the strategies involved. Hopefully this week I got you to think outside the box a little bit.

Good luck trading.

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