Further derivatives could stabilise crypto currency, making it more mainstream
Bitcoin options are what is needed to tame this beast
The seminal financial event of this year, the current decade, and possibly our generation is here: futures trading in bitcoin has begun.
But the derivative that would really damp the current crypto frenzy and make digital tokens a speculator-friendly — if not investment-worthy — commodity, currency, tulip, or whatever, isn't futures. It's options.
Options could supplement futures contracts in damping irrational exuberance for bitcoin.
It's hard to see how even existing futures trading rules can deal with something as volatile as bitcoin. Cboe Global Markets Inc. began offering them on Sunday, and soon they'll be available on CME Group Inc. Brokers including E*Trade Financial Corp., TD Ameritrade Holding Corp. and Ally Financial Inc. will probably follow suit. If last week's price movements are mirrored in futures contracts, trading would have to be paused or suspended a number of times throughout the day.
The hope is this chaotic state of affairs will change. Once it's possible for large pools of institutional liquidity to bet against an irrationally high (or low) futures price in relation to the spot, the latter will also steady. To speed up stabilisation, though, you need options.
A one-month futures price of, say, $16,000 only tells you that if you sell a bitcoin when it's going for $16,704, and buy a futures contract expiring in a month, you're effectively earning a bitcoin rate of interest of 57 per cent, annualised.
Whether investors judge that to be too high or too low given all the other interest rates in the economy, including, most importantly, the U.S. dollar one of 1.52 per cent, will see spot and futures prices adjust accordingly.
That discovery would be a lot quicker if extreme views — those who think bitcoin will be $100,000 in a month and those who bet it'll be $1,000 — get squeezed out of the market.
What futures prices won't tell us is the dispersion of expectations and their probabilities.
Pelham Smithers Associates and Albert Maass have done a useful analysis of bitcoin options on futures contracts that currently trade on Deribit, a European derivatives bourse for the digital currency. They constructed an at-the-money "straddle" around a strike price of $12,000 on Dec. 5 by buying two bitcoin call options for that amount and one put. The structure would only make money if the March futures price went above $18,000 in a month (i.e., by early January), or fell to $9,000 or less.
An at-the-money straddle on bitcoin options on Deribit on Dec. 5 was profitable only if the price of the futures contract rose by at least 50 per cent, or fell by 25 per cent, in a month
Bitcoin options, in their current form, only reward expectations of abnormality: a price gain of 50 per cent or more, or an erosion of at least 25 per cent, in one month. As the analysts noted, "options are so rich, you need a big move up or down in bitcoin to justify their price."
A straddle on the British pound, by contrast, would make money if the exchange rate moved by just 2 per cent either side.
Put another way, extreme views are ruling bitcoin. The only antidote is to have a mainstream venue like CME or Cboe offer options, so that irrational exuberance (or pessimism) is edged out. Exchanges, however, are already getting flak, including from some of the world's biggest derivative brokers, for rushing the contracts to market without thinking through the risks.
For the foreseeable future, bitcoin options look set to remain a boutique parlour game, where cranks will dominate. That's a missed opportunity to tame this beast.
Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.