Implied Volatility in Crypto Options

Introduction to Volatility

When we talk about vol, we mean volatility – not volume.

Volatility is the measure of how much an asset’s price can change over a short period of time, a commonly known concept in financial markets. 

The more violent the directional moves in price, the more volatile the markets are.

In options trading, there are different ways to interpret market volatility – namely implied volatility (IV) and historical volatility (HV). These measures are essential in determining the profitability of different types of options. Vol also has profound implications for options pricing and the options Greeks.

To learn more about the interplay between volatility and The Greeks, check out our latest Masterclass inside Premia Academy.

Besides implied volatility, we’ll also talk about DVOL (Bitcoin volatility index) and useful ways of utilizing or interpreting it. First and foremost, let’s properly discern the terminology and preface in preparation for the more practical stuff.

What makes IV and HV any different from plain old vol?

Volatility is a measure of how much the price of an asset can change over a period of time.

Implied Volatility derives from the asset price and represents the market’s expectation of future volatility – a forecast of sorts.

Historical Volatility is a statistical measure of past price fluctuations over a period of time.

Implied Volatility: Forecasting Vol

Think of IV as a weather forecast – an expectation of the likelihood of changes in the price of an asset such as Bitcoin or Gold.

Implied volatility is a metric used by traders and investors to estimate future fluctuations in the price of a given asset based on multiple predictive factors. It’s important to remember that IV is merely a prediction based solely on prices, not fundamentals.

Traditionally, IV can also be thought of as a proxy of market risk, although highly volatile environments are often the comfort zone for crypto-natives… 

Regardless, the different ways of measuring volatility are fundamental to understand for options traders, as different strategies yield different returns in different conditions.

Besides plain ol’ charts, there’s also a way of visualizing IV with an implied volatility surface.

The volatility surface provides a visual representation of IV against strike prices and expiration dates. Think of it as a topographic map, with peaks indicating higher IV and valleys showing lower IV, reflecting the market's expectations of future price movements.

A steep slope on this surface can suggest that the market expects significant price changes, while a flatter surface might indicate a calmer outlook.

Traders can use this surface to gauge the relative cost of options, to identify trading opportunities, and to inform their strategies.

Historical Volatility: Realized Data

Historical Volatility (also known as realized volatility) measures the past price movement of an asset over a specified period.

Realized volatility can be used to find correlations and historical patterns, as well as used as an indicator of the actual price risk of an underlying asset.

The chart above helps us visualize the differences between the IV and HV of BTC over a specific timeframe.

By comparing these two measures, traders can identify overpriced or underpriced options, market volatility trends, and ultimately make more informed decisions. The chart can also help time trades during high or low volatility periods, manage risk by understanding the relationship between IV and historical volatility, and select appropriate trading strategies based on current market conditions.

For example, if IV > HV, it means that the markets expect unusually high volatility in the underlying asset. Among other potential implications, this means an option might be overpriced on average, signaling traders to sell premiums.

Bitcoin Volatility Index (DVOL)

We often cover changes in DVOL and the relationship between HV/IV on Marty’s Market Data newsletters. Read the latest issue here; the alpha is free on Mondays.

DVOL is a Bitcoin Volatility Index – simple, tradable volatility exposure on Bitcoin.

The DVOL is forward-looking volatility, meaning it can be used as a point of reference for the market’s expectation of vol. It gives the 30-day (forward-looking) annualized expectation of volatility.

Here are some ways to utilize or interpret DVOL:

1. Gauge market volatility: DVOL helps traders understand the asset’s volatility, which is important for options trading.

2. Make decisions: By examining DVOL trends, traders can make informed choices when buying or selling options.

3. Spot opportunities: Analyzing DVOL charts can reveal periods of unusually low or high volatility, potentially highlighting trading opportunities.
   

4. Manage risk: Tracking daily volatility helps traders adjust their positions and hedging strategies to manage risk.

5. Compare assets: DVOL charts for different assets, like ETH and BTC, allow traders to compare volatility profiles and choose which asset to trade.

Applying Implied Volatility in Options

Understanding implied volatility is not just about grasping a theoretical concept; it's about applying this knowledge in real-world trading scenarios to enhance profitability and manage risk.

For the sake of this article, we won’t dive too deep into specific topics but encourage aspiring options traders and market researchers to read further. Also,  there will be even more advanced content on the Premia Academy soon…

Here are some straightforward ways to apply a certain sentiment in practice:

1. Shorting Volatility: Traders that think an asset like BTC or ETH will stagnate in price might opt to passively sell options on that asset to net a premium. Vaults on Premia Blue are designed to automate that process while earning depositors a share of PREMIA Call Option rewards.

2. Longing Volatility: Traders that anticipate volatility but are unsure of the direction might employ strategies like strangles or straddles, which stand to make a profit if the underlying asset moves greatly in any direction.

Here are some practical applications of IV in options trading:

• Option Pricing: IV is integral to option pricing models, such as the Black-Scholes model. By understanding IV, traders can determine whether an option is over- or underpriced relative to the market's expectations of volatility.

• Strategic Trading: Different levels of IV suggest different trading strategies. High IV may indicate potential for selling options due to higher premiums, while low IV could make buying options more attractive due to cheaper premiums.

• Volatility Skew Analysis: Traders can examine IV across different strike prices and expiration dates to understand the volatility skew. This can indicate market sentiment and potential price movements.

• Risk Management: By monitoring changes in IV, traders can adjust their portfolios to manage exposure to volatility. This may involve hedging strategies that protect against unexpected market movements.

• Earnings Reports and Events: Events such as earnings reports can affect IV significantly. Traders can position themselves ahead of these events by analyzing IV to predict changes in option prices.

• Volatility Arbitrage: Traders can exploit discrepancies between IV and HV through volatility arbitrage, taking positions that will benefit from a reversion to the mean if the market's forecast of volatility is out of alignment with historical patterns.

All in all, implied volatility is a dynamic indicator that can guide options traders through the complexities of employing different strategies in different conditions. Additional concepts like Vega, volatility skew, and vol arbitrage will all prove quite useful to understand once you get the hang of it.

This article is a surface-level overview of interpreting vol. To learn more about options, risk management, and IV in practice, I wholeheartedly recommend checking out the more advanced Masterclasses inside the Premia Academy.

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