Navigating 'Tail Risk' Apprehensions: Bitcoin Traders' Sentiments During the Renewed Price Lull
Tail risk refers to the potential for an asset to experience a significant price movement of three standard deviations from its current price due to an uncommon event.
The increased value of out-of-the-money call and put options linked to bitcoin suggests that traders are accounting for the presence of "tail risk" within the bitcoin market. This term indicates a higher likelihood of an investment undergoing a substantial deviation from the mean by more than three standard deviations.
This concept of tail risk has become pertinent in the cryptocurrency space, particularly concerning bitcoin (BTC). Despite bitcoin's recent lack of substantial movement around the $26,000 threshold following a 10% decline in the week ending on August 20th, traders are uneasy about the possibility of such an occurrence. Data from Amberdata shows that BTC's seven-day historical volatility has decreased from nearly 60% to 26% on an annualized basis.
Griffin Ardern, a volatility trader at the crypto asset management firm Blofin, remarked, "Bitcoin's butterfly index has reached its highest level this year. This signals that investors and market participants are factoring in tail risk."
The butterfly index serves as a gauge for the relative value of out-of-the-money (OTM) options, including call and put options. This is achieved by comparing Deribit's bitcoin volatility index (DVOL) with the volatility of at-the-money (ATM) options.
An elevated butterfly index suggests a stronger demand for OTM options, both calls with strike prices above the current BTC value, and puts with strike prices below the prevailing market rate. Essentially, this reflects traders' concerns about tail risk and their heightened sensitivity to uncertainties.
Calls and puts are derivative contracts that offer the right to purchase or sell an underlying asset at a predetermined price on a future date. Calls convey bullish sentiment, while puts signify a bearish outlook. Demand for OTM calls and puts tends to increase when traders anticipate significant price fluctuations.
Upon analyzing the BTC butterfly index, it becomes evident that the wings (OTM options) are approaching the upper 90th percentile. This suggests that despite overall volatility metrics hinting at price stability, traders are still willing to pay a premium for protection against tail risks. Greg Magadini, the director of derivatives at Amberdata, highlighted this in a weekly newsletter.
This index is expressed as a ratio between Deribit's bitcoin volatility index (DVOL) and the volatility of at-the-money (ATM) options. Deribit's DVOL encompasses pricing for all options, while the ATM tool focuses on pricing for options with strike prices at the prevailing market rate.
The consideration of tail risk pricing resonates with the ongoing uncertainty in the broader macroeconomic landscape. Recent statements by Federal Reserve Chairman Jerome Powell regarding the commitment to achieve and sustain 2% inflation, along with indications of prolonged tight monetary policy, have led to elevated bond yields, the highest since 2007. Rising bond yields typically exert pressure on risk assets, including cryptocurrencies.
Greg Magadini pointed out that Powell's approach implies that achieving the 2% inflation target may require accepting below-average economic growth, indicating a willingness to withstand certain economic and job market challenges.
Looking ahead to the upcoming U.S. nonfarm payrolls report, Griffin Ardern suggested that tail risk is likely to remain elevated. According to the Wall Street Journal, the data is anticipated to reveal the addition of 200,000 jobs in the previous month, following a rise of 209,000 in June, while the unemployment rate is expected to remain steady at 3.6%.