As much as cryptocurrencies are notorious for being highly volatile, the ability for retail investors to access derivative instruments like options and futures, allows for us to establish positions that traditionally were the sole purview of professional traders.
Addressing the notion of volatilty
To understand this, we need to understand why is volatility commonly seen as bad?
To many investors, the volatily of cryptocurrencies can be off-putting. Especially when they witness graphs like the one above, where large swings are accompanied by large falls.
The huge potential of making losses.
What exactly is Delta (Δ)?
If you come from a Math or Engineering background, Delta (Δ) is the Greek symbol denoting rate of change.
For instance, Acceleration is the rate of change of speed.
In the world of finance, the same notion applies to Options.
Delta is the change of the price of a derivative, compared against the change in price of the underlying asset.
If an Option has a delta of 0.3:
$1 change in the price of an asset => $0.30 change in the price of the Option
What is Delta neutral?
Using a similar lens that is math/engineering, we can ask:
What is the rate of change of the mass of the car (excluding fuel), measured against speed?
Zero.
The components of the car do not change regardless of the speed of the car.
Similarly, we can create investment positions that are almost 100% immune to the large rises and falls of cryptocurrencies.
The following segment assumes a working understanding of options theory.
What are conversions and reversals?
In options theory, conversions and reversals consists of overlapping long and short positions that mutually offset.
A conversion consists of the following legs:
- Short selling a call option
- Purchasing a put options
- Purchasing the underlying asset
A reversal consists of the following legs:
- Short selling a put option
- Purchasing a call options
- Short selling the underlying asset
Creating positions on Deribit
Deribit is a major crypto derivatives exchange that enable us to trade Perpetuals/Futures/Options on major crypto currencies.
Establishing a reversal using the Deribit position builder
The chart below shows a short position in Ethereum, using perpetual swaps.
As expected, a short positions gains when the asset falls in value, and losses, when the asset falls.
Next, we see a synthetic long position created using 2 options contracts.
- Long call 19 Apr 2024,3400 strike
- Short put 19 Apr 2024, 3400 strike.
By combining both long and short, we can succesfully remove all directional risk from our position.
Our net gain is the difference in the premiums of our long and short option positions.
Regardless of how Ethereum performs, we can rest assured that our position sits in a profit :)
*Disclaimer
You may notice a slight upward sloping gradient in the graph.
In reality, it is impossible to eliminate directional exposure 100%.
When trading, we frequently have to contend with trading fees payable to the exchange that eliminate a slice of our profits.
Additionally in the case of perpetual futures, the funding rate also eliminates a slice of our profits.
