When market makers sell out-of-the-money calls, they hedge their short delta risk by buying shares.
Author:Jay
Compiled by: TechFlow
Kenny G wins again
So why are cryptocurrency stocks underperforming?
I will explain the fundamental dynamics of how the options market affects the underlying stock price.
An important factor is the upcoming monthly options expiry (mopex), which will take place this Friday, November 17th - specific dynamics include:
Expectations of price volatility are too high
Market Makers Unwind Hedging Operations
I’ll use Coinbase as an example, but these factors apply to almost all cryptocurrency stocks.
I mentioned earlier that after Trump won, you needed to look at implied volatility before considering buying call options because of the dynamics I’m about to describe.
Here are Coinbase’s implied volatility data for expirations on November 15, 22, and 29.
A volatility of 132% means that with a 95% probability, the underlying asset’s daily price fluctuation is expected to be 16.62% up or down. This expectation is very high.
The implied volatility percentile for the past 30 days is at 80%. This means that over the next 30 days, this implied volatility (or expectation of Coinbase going up) is higher than 80% of the time in history. This is unusually high in the absence of a quarterly earnings call.
So what happens when market expectations are so high? What are the actions of market makers at this time?
When market makers sell out-of-the-money calls, they hedge their short delta risk by buying shares.
As expiration approaches, the delta of these out-of-the-money calls decreases, and therefore, market makers sell the shares to avoid directional risk.
As we approach November 15, the rate of delta loss for out-of-the-money calls accelerates (assuming all else remains constant).
Looking at option open interest, we can see a clear bias towards out-of-the-money calls (puts are barely visible on the chart).
As the expiration date approaches, the market becomes more directional due to the reflexive effect of market makers’ hedging behavior. As a result, market makers are more aggressive in selling shares (unless there are other entities that are more aggressive in buying Coinbase).
At the same time, the cycle is reinforced as investors take profits (closing call options and market makers selling hedged stocks). This forms a large reflexive loop.
How did we get here?
Last week, Coinbase’s options open interest looked very bearish (as can be seen from the historical put-call ratio and the 25 delta skew).
Trump’s victory led to massive position unwinding (resulting in the exact opposite of what I described earlier), with market makers buying back shares as their short put options were unwound.
The market pendulum swung violently in the opposite direction, and the implied volatility (price) of these options rose sharply – with this change, the delta of the out-of-the-money calls increased (hedges therefore became more aggressive, and inevitably unwound).
Expectations of price movement have shifted excessively in the positive direction due to short covering, market makers unwinding hedges, and widespread expectations of a “super cycle.” This is reflected in the implied volatility of all cryptocurrency stocks.
This is why I choose to sell a lot of volatility at this time - these expectations are rarely realized, and it is also a good strategy to hedge spot.
