BlackRock's BTC ETF IBIT options approved: What impact will it have on Bitcoin and how to arbitrage
Overview:
SEC approval of IBIT options is a watershed moment for Bitcoin, and options can greatly enhance liquidity.
Options trading on IBIT will unlock new pools of funds, allowing institutional investors to participate in BTC investment with confidence while reducing downside risk.
IBIT’s dominance in the Bitcoin ETF space will accelerate, providing both spot market access and the flexibility of options trading.
I discussed the reflexivity of the gamma squeeze and how it affects the price of BTC in a rational expectations model.
The approval of IBIT options solidifies BTC’s position as a premier asset.
On Friday, September 20, 2024, the U.S. Securities and Exchange Commission (SEC) approved the listing and trading of American-style options on the iShares Bitcoin Trust ETF (NASDAQ: IBIT). Approval from the Office of the Comptroller of the Currency (OCC) and the Commodity Futures Trading Commission (CFTC) is still required, but the SEC's approval means the hardest part may be over. The listing of IBIT options will be a watershed moment for Bitcoin (BTC-USD), with an impact that could be even greater than the approval of the spot ETF in January. This article will analyze the consequences of this development and expand on some Bitcoin options strategies that are currently available to most U.S. investors.
background
It is essentially impossible for US investors to get any decent quality BTC options. The premier BTC options trading venue has been Deribit, a Panama-based options exchange. Deribit supports 24/7/365 trading of BTC and ETH options, as well as perpetual futures products on a number of major crypto assets. Options are European-style and settled in the physical underlying cryptocurrency. Deribit users have access to portfolio margin and leverage, similar to the capital efficiencies offered by SPAN margin in traditional financial markets (read: something you can get from Interactive Brokers). Being crypto-only, Deribit users cannot cross margin with assets in traditional portfolios like ETFs and stocks. Deribit is only available to US citizens.
US investors can visit LedgerX, a CFTC-regulated crypto options exchange. LedgerX is fairly limited in its functionality. First, the bid-ask spread on LedgerX is very wide. Second, there is no margin at all. While Deribit users can trade naked options, every call option on LedgerX must be sold for money (owning the underlying BTC) and every put option must be sold for cash (owning the cash value of the strike price).
Another possibility for US investors is to trade BTC futures options. For example, /BTC and /MBT are BTC futures traded on CME. Both products have their own options on the futures products. These options can be cross-margined with other products in the portfolio, but they also have very wide bid-ask spreads. Regulatory fees for futures options also tend to be much higher.
The last option for US investors is to trade options on assets that are correlated to BTC. MicroStrategy options could potentially be used as a substitute. Another option is BITO options. However, the problem is that both MSTR and BITO suffer from significant tracking error from BTC, despite very high daily correlations.
The lack of a truly satisfying venue for BTC options trading has arguably inhibited BTC adoption over the years. Most of the well-known assets have deep options markets. SPY, QQQ, and IWM are all daily expirations and dominate the entire market in terms of options volume. There are also SPX and XSP index options, which are extremely liquid. HYG, SLV, GLD, and TLT options have lower options than the major US stock indices and their ETFs. Options volume on these options is also very high. For a full list of ETF volume breakdowns, you can check out this tracker. On the equity side, each of the big seven has very deep options markets. The point is, having liquid options is an undeniable sign of an asset's credibility.
From another perspective, BTC’s market cap is comparable to that of silver. However, the US market does not offer any BTC option chains that are even remotely similar to SLV options. Therefore, the approval of IBIT options is a huge credibility stamp that puts BTC in a very prominent position among all assets.
Impact 1: Liquidity from options traders
The first big impact is that options create more liquidity for the underlying asset as options traders (i.e. market makers) engage in dynamic hedging strategies. When trading options, traders often hedge their exposure by buying or selling the underlying asset (in this case, BTC or IBIT ETF shares). This constant buying and selling by options traders provides a steady flow of trades, smoothing price fluctuations and increasing overall liquidity in the market. The resulting liquidity not only benefits traders seeking tighter spreads and deeper order books, but it also helps stabilize the market, especially during periods of high demand or increased volatility. One effect of this increased liquidity is that it allows a larger pool of capital to enter the market while reducing slippage.
Impact 2: Tactical hedging releases more liquidity
The launch of IBIT options will unlock new pools of capital that were previously hesitant to enter the BTC market due to risk management issues. Institutional investors, especially those managing large portfolios, often require sophisticated instruments to hedge their positions before committing large amounts of capital. By employing tactical hedging strategies through IBIT options, these investors can participate in BTC investments with greater confidence while reducing downside risk. This ability lowers perceived risk barriers, allowing more capital to flow into the market. As these new entrants use IBIT options to hedge and protect their investments, the cumulative effect will significantly increase liquidity, further solidifying BTC’s place in global asset allocations.
I want to emphasize the importance of this in particular. You see, many institutional investors manage large portfolios with very high and specific requirements for risk management, buying power, leverage. So far, many of them are still on the sidelines of BTC because spot ETFs alone won’t solve the problem, and real BTC certainly won’t solve the problem. Options on marginable securities like IBIT are the perfect complement to introduce marginal investors to Bitcoin.
First, many institutions can now hold a Bitcoin ETF and then use the buying power of their accumulated portfolio to build tactical options hedges for the ETF position. Second, many institutions can choose to ignore the spot ETF entirely, but use IBIT options to construct very precisely defined risk returns based on BTC's price action. Now recall impact 1 - all of this derivatives volume comes from options traders, many of which will be exposed to the spot market to hedge the options they are trading. Therefore, the increase in liquidity comes from many different aspects, some of which are self-referential and highly reflexive.
Third, think about all the covered call funds we have now that generate income while holding the asset. With the approval of IBIT options, funds can finally earn the yield of QYLD, MSTY, TSLY, TLTW, etc., but on BTC. A covered call fund manager can hold IBIT and then sell IBIT calls on a weekly or monthly basis at about 5% OTM. Given BTC's massive IV, this could generate significant income. This is yet another example of options directly opening the door to more liquidity, as the list of things that can be done with options now expands.
One final point worth noting is that options are probably the most important derivatives because they can be used to construct all of the other positions. Want a forward contract? That’s buying a call and selling a put, both with the same strike price and expiration date. Want exposure to volatility regardless of direction? That could be a straddle: buying a call and a put, both with the same strike price and expiration date. All in all, options can create very complex structured products, all of which can help get more institutional capital involved in BTC. A very viable example might be BTC-backed loans. As a financial institution, if I can find a way to effectively hedge the risk associated with BTC, I might offer a BTC-backed loan. That’s what structured products do! These are usually created by purchasing a specific basket of options.
Impact 3: IBIT’s dominance will only accelerate
As more investors flock to IBIT to take advantage of options, I think its dominance in the Bitcoin ETF space will accelerate dramatically. The ability to trade options will make IBIT a more attractive tool for those seeking to invest in Bitcoin with a broader strategy. By providing both spot market access and the flexibility of options trading, IBIT will stand out from other spot ETFs.
At the simplest level, IBIT holders can now earn income through covered call options without using any buying power. If you hold FBTC, then you can only sell IBIT call options by using your buying power. This reduces your capital efficiency because it means you cannot use that buying power in other trades.
Since IBIT is the first company to get options approval, IBIT's options volume is likely to remain "stable" even as options on other spot ETFs are also approved. Capital inflows into IBIT are likely to far exceed those of other competitors, solidifying its dominance as the preferred Bitcoin ETF. There are some long-term risks to IBIT's increased dominance, but I will cover these in the risks section.
Impact 4: Thanks to the absolute scarcity of BTC and the dynamics of options Greeks, market reflexivity reaches an unprecedented upward trend
This question is very complex. I think it is best to first discuss the GME short squeeze in January 2021, and then discuss why squeezes in any asset are fundamentally unsustainable. Finally, we will discuss why BTC is different and how these choices will affect BTC's valuation in the future.
What happened to GME in January 2021 was more than just a short squeeze. Perhaps the more important aspect of this was the use of weekly call options, which created a gamma squeeze. The very short expiration of these options (less than 14 DTE) meant that they had huge gamma. Gamma is the second derivative of the option price with respect to the underlying price. In other words, it is the first derivative of the option delta with respect to the underlying price. In short, gamma is the spot price convexity of any option contract. Gamma is one of the biggest reasons why option traders hedge “dynamics”. As the price of the underlying asset moves, it will change the delta of the option through gamma. A gamma squeeze is a phenomenon where directional traders buying short-dated OTM call options causes dealer delta and gamma to be severely negative. To hedge the risk, dealers would go out and buy shares until they were delta neutral. However, the negative gamma would remain on the dealer books unless it could be offset by buying more options. As the price of GME rose, likely due to the initial dynamics of the short squeeze, the OTM call options moved closer to the ATM. ATM options are actually where gamma is highest. So starting with the first phase of the GME rally, a lot of the negative gamma swells to a larger magnitude. At this point, every incremental increase in the GME spot price forces a larger incremental change in delta (remember, changes in delta are determined by gamma). This forces dealers to buy more GME as many weekly options approach ATM. But this buying, of course, drives prices higher, which causes more and even further out OTM options to approach their ATM prices and reach their maximum gamma. The dealer-driven buying doesn’t stop even as the call becomes ITM. Gamma decreases as the call becomes ITM further, but it remains positive for the long option, which means delta continues to increase. The drive to hedge against the increasing negative delta is what forces dealers to keep buying shares.
This is a gamma squeeze, which occurs when directional traders buy call options in large quantities. To be clear, directional traders did not orchestrate the triggering of a gamma squeeze. Gamma squeezes tend to occur naturally when prices are rising (perhaps due to a short squeeze) and traders want to take advantage of short-term upside at a low price, so they buy expiring call options.
So why don't these squeezes last, and why do stocks that get squeezed tend to fall back to pre-squeeze levels? The answer isn't actually "fundamentals don't justify this higher price point." Remember, if we're basing this on the long-term average of the P/E ratio, fundamentals don't justify most of today's price points. The answer to all price changes is always supply and demand.
A sudden and parabolic rise in price is almost always caused by a sudden and parabolic rise in demand. When prices rise that high, it signals to all producers of the underlying asset to start producing more supply to meet that demand. That's what drives prices down. When a stock experiences a gamma squeeze, the company issues more shares and sells them into the market. This is exactly what happened with GME, AMC, and the other meme stocks that have skyrocketed in 2021. Even when commodities experience dramatic price increases, you can bet that the producers of the commodity are now working overtime to meet demand. When Russia imposed sanctions, natural gas prices rose. Natural gas producers around the world also began producing more natural gas, which obviously increased supply and brought natural gas prices back down to pre-sanctions levels. The chart shows exactly what happened.
The reality is that every commodity, stock, debt, currency goes through this dynamic. If the price is really, really attractive to the producer or issuer, more supply is created to meet the demand. There is only one major asset that deviates from this rule: Bitcoin.
There are only 21 million Bitcoins. This is a programmatic fact that cannot be changed unless full nodes, miners, and users all agree to switch to another code that governs the Bitcoin network. This consensus change is essentially impossible. Therefore, Bitcoin is absolutely scarce. Linking this to options, if a gamma squeeze occurs on IBIT, there will be no elastic supply that can produce more BTC. The only sellers will be those who already own BTC and are willing to trade it at a higher USD price. But this brings up a big problem - it doesn't make much sense for them to take advantage of the situation to sell, because everyone knows that more BTC will not suddenly be created to meet this demand that drives the price down. And this fact will affect all decisions related to the situation. I just want to clarify. I'm not saying that no one will sell BTC. What I mean is that when you compare BTC holders and GME holders, both of which have their own hypothetical gamma squeezes, one of them obviously has a greater incentive to sell because they know that more supply will be created, thus driving the price down. This comparison applies to any asset holder vs. BTC holders. Holders of silver or oil know that more supply is coming, not from other holders, but from the miners and drillers who pull it out of the ground.
Therefore, if IBIT options are listed, there is now a possibility of a truly huge and sudden gamma squeeze rally. In addition, due to the absolute scarcity of BTC, there is also the possibility that this rally will last longer than rallies in other assets. Now this is a factor that should be reasonably factored into the BTC valuation model. Since this is possible, what is the new expected value of the BTC price? Since the probability is positive, the additional boost to the expected value must also be positive. This constitutes a continued increase under the rational expectations model of BTC valuation.
Actionable options trading
I think the biggest benefit for retail investors is that they can now participate in the volatility that BTC is famous for. BTC has an annualized volatility of 50-100. That is many times the volatility of SPY or QQQ. It is much more volatile than GLD or SLV, and certainly over 10x more volatile than TLT or HYG at times. Of course, the best measure of BTC IV right now comes from the best place for BTC options right now: Deribit. Here is a time series of BTC DVOL.
DVOL is short for "Deribit Volatility". The DVOL method is essentially the same as the VIX method. Both use the two options closest to the 30 DTE expiration date, throw away some illiquid contracts, and use a variance swap formula to calculate model-free implied volatility (i.e. not affected by the Black-Scholes model). Compare this to the VIX, which currently reads below 17 and is usually around 12. Bitcoin options in the form of IBIT options allow U.S. investors to enter the world of IV in BTC. If done correctly, this could lead to significant returns.
The simplest trade is a cash secured put or naked put. Basically, just sell puts in the 40-25 delta range. The long bias of BTC is up, so the puts are like a way to get paid to buy a possible future decline. If BTC continues to go higher, then you get to keep the entire premium. You can also be more aggressive with puts and sell ATM. This will result in a larger premium. I have never seen a backtest of consistently selling ATM BTC puts, but backtests of doing the same with SPX puts all look pretty impressive. For the IBIT puts, I guess this is thanks to the much higher IV of BTC.
I am personally considering combining a short OTM put with multiple long OTM calls. This would create an "enhanced" futures position where the upside becomes more convex, approaching multiple 100 shares of IBIT stock, while the downside drops to a long position of just 100 shares of IBIT stock. Since puts tend to have higher IV than calls, it is sometimes possible to short one put and buy two calls without any debits.
risk
There are several risks worth mentioning. First, this all depends on whether BTC continues to gain wider adoption and acceptance as an asset. A significant drop in BTC price could render this argument irrelevant. But this risk is practically tautological.
As IBIT's dominance grows, I think the tail risk is that Coinbase, as a custodian, is becoming one of the largest hacker honeypots the world has ever seen. Personally, I have been holding FBTC in my retirement account because Fidelity is custodial on that BTC. Can I move to IBIT so I can sell covered calls now? Maybe, but personally, I don't have much interest in covered calls. I don't like the approval of options that will almost certainly increase the size of the Coinbase honeypot at a much faster rate.
Another tail risk I can see has to do with BTC trading 24/7 year-round, while IBIT and options on IBIT only trade during traditional market hours. My concerns are two-fold.
First, I would be very careful about holding a short volatility position in IBIT over the weekend, because there is simply no way to close out the position when BTC moved 15% in 6 hours on Saturday. Technically, it doesn't even have to be a weekend for major problems to occur. Even an overnight short volatility position is highly risky because BTC could move 15% anytime between 16:00 ET and 09:30 ET and you can't close out the position. Stop losses are good for normal options trading. When I trade SPY options, I set stops. But they work because SPY never trades when my options don't trade. This is not the case at all with BTC and IBIT options.
Secondly, I am concerned about the extremes that the options market could create, which could cause random high volatility in BTC and possibly a NAV crash in IBIT. I am not sure exactly how this will play out, but I think the very high IBIT gamma at the market close on Friday could force traders to have to buy real BTC over the weekend to hedge their deltas. Now, since IBIT is a cash redemption, there could be some risk in moving real BTC between IBIT shares. All of these risks could eventually spill over into the BTC market. We could randomly see bid-ask spreads widen and order book depth thin out in response to major events.
in conclusion
Overall, I think the approval of IBIT options is an extremely important moment in Bitcoin's history. It further solidifies BTC as a premier asset. It opens the door to more liquidity. And it opens up all sorts of interesting new possibilities for derivatives-savvy investors.
I have long argued that Bitcoin ETFs are not as influential as people think. Most of the inflows are related to basis and pairs trading and have nothing to do with a bullish view on the asset. However, the introduction of options on the largest spot ETF could dramatically change this dynamic. As I have laid out here, the versatility of a liquid options chain has sparked bullish sentiment in a classic reflexivity of the market. Liquidity brings more liquidity, and optionality brings liquidity that has been sitting on the sidelines - all of which brings more liquidity. Now that they have a full suite of tools to do fine-tuned and capital-efficient hedging, much of this liquidity will continue to be there.
BTC and IBIT are worth buying. Options are a watershed moment, we are still 14% below the all-time high and have just started a rate cut cycle. The macro situation is absolutely great.
The above content is shared by Stony Chambers Asset Research
