Six Long Volatility Strategies in DeFi
“They were the best of times, they were the worst of times,” as Charles Dickens said. Looking forward, I have a feeling these aren’t going to be the best of times. Geopolitical instability all over the world came to a climax in the war between Russia and Ukraine, which is now causing an energy crisis in Europe. On top of political risks, there are significant economic and financial risks. High rates of inflation all over the globe have led to interest rate hikes. As a result, economic activity is declining, which could be yet another sign of a global recession.
All these factors can impact financial markets, causing large swings in almost all asset classes. A surge in market volatility creates a lot of opportunities. In light of this, I decided to write an article on long volatility strategies
Long volatility strategies seek to benefit from high volatility in the markets. Long vol strategies don’t bet on the market direction; instead, they benefit from a surge in volatility, which means they perform well when there are large price moves.
The main advantage of these strategies for investors is that they have a negative correlation with equities. That is, long vol strategies tend to perform well when the stock market goes down. Their overperformance in an adverse market environment makes long vol strategies a perfect addition to the traditional portfolio. Since they typically involve buying options, they have a limited downside and an unlimited upside.
1. Out of the Money Put Options
ETH Put Options on Hegic
Now that we understand long vol strategies, we can ask: what are some long vol strategies in the crypto market? One of the simplest of these strategies may be buying out-of-the-money (OTM) put options on Bitcoin. If the market crashes, we’ll benefit from it by holding put options. We can also consider buying OTM call options, though for those who hold Bitcoin it may be unnecessary.
2. The Crypto Volatility Index
We can long volatility directly, too. Developed by the COTI team, CVI (Crypto Volatility Index) allows us to do so. CVI Index measures the expected volatility of the crypto market based on the cryptocurrency option prices, and it is calculated based on the 30-day average of options prices on exchanges. If the volatility in the crypto market goes up, the token appreciates.
The Crypto Volatility Index
CVI index can be traded for hedging purposes, especially if one expects big moves in the market. During such events, the crypto market can be highly volatile. The sharp spikes on the chart below support the notion that sometimes crypto traders may experience wild swings like we saw in the beginning of Coronavirus crash. The highest value of CVI was 158.4 on 17 May 2021, when Tesla CEO Elon Musk tweeted that the carmaker company may stop taking Bitcoin as payment due to environmental concerns. As a result, Bitcoin lost 27% of its value in that week, which drove the whole crypto market down.
3. Momentum Trading
Another trading strategy that benefits from high volatility is momentum trading. Momentum trading is buying assets overperforming in the lookback period and shorting underperforming assets. When volatility increases, both winning and losing assets tend to continue their recent performance; therefore, buying recent winners and shorting recent losers make sense.
When researchers backtest momentum strategy in equity, bond, or commodity markets, they usually look back to the asset’s performance over the past 3 to 12 months, dropping the last month because the last month tends to exhibit a reversal (mostly due to profit taking). The holding period in this type of strategy is typically 3-6 months.
DeFi is more dynamic, fast-paced, and volatile than traditional asset classes, though. Therefore, I personally modify the parameters as follows: 49 days of lookback window (how many days of data we will look at), ignoring the last 14 days data and holding for a period of 7 days.
4. Insurance Protocols
When there’s a surge in the volatility of the DeFi space, the probability of weak DeFi protocols underperforming increases. This makes buying an insurance coverage on DeFi protocols on decentralized insurance protocols a viable option. InsurAce is one example.
5. Shorting DOV Protocol Tokens
Shorting DOV protocol tokens would also be a profitable long vol strategy. Decentralized option vaults are structured products that sell options on a user’s tokens. They collect deposits from investors and sell options, which means they are essentially short volatility strategies. When volatility in the crypto market spikes, it’s reasonable to expect that short volatility strategies will suffer huge losses. In a high-volatility market environment, I suggest shorting the tokens of token protocols, such as RBN which is the governance token of the Ribbon Finance, the largest crypto structured products protocol on Ethereum.
6. Stablecoin Depegs
An Example of Y2K Finance in Use
Yet another strategy capitalizing on surging volatility in DeFi could be shorting stablecoin perpetuals swaps. Perpetuals, or perps, are similar to futures in traditional finance that allow you to bet on the direction of the asset price. If you go long aluminum futures, you’ll make money if aluminum price increases. Otherwise, you’ll lose money.
Stablecoins are generally perceived to be a safe haven in the crypto market. But in turbulent periods stablecoins tend to depeg, or lose their peg to the US Dollar (or any fiat currency). For example, during the Coronavirus crash, nearly all large stablecoins experienced a deviation from their peg and traded at a discount to $1. So, holding a stable coin is like a short volatility strategy – most of the time nothing extraordinary happens and the coin keeps its peg. But in the hard times it will depeg, leading to large losses for investors. Shorting a stablecoin perp is exactly the opposite of this, hence it’s a long vol strategy: most of the time you’ll lose small being on the wrong of the trade, but when a disaster happens, you’ll win big.
Alternatively, Y2K Finance provides another means of indirectly banking on extreme volatility. Offering a suite of structured products for exotic peg derivatives, users can essentially use the platform to hedge or speculate on the risk of a pegged asset deviating from its “fair implied market value.”
For most of its existence, crypto has been notorious for its above average volatility, making it a boon for traders capitalizing on violent swings in asset prices. While things have been unusually calm for the past few months, we can only assume it will return to form sooner or later. These long volatility strategies may be an ideal way to gain some edge when it finally does.
Published on Oct 27 2022