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Decentralized options trading has seen exponential growth in 2024 with a high IV across various AMMs.
Over the past few decades, crypto investors have predominantly focused on spot trading. However, with growing interest in derivatives, options contracts on cryptocurrencies have gained significant traction. In June 2024, crypto options saw a strong trading surge. The overall BTC and ETH option interest notional value has reached around $29 Billion. Traditionally, crypto options were traded on centralized exchanges (Off-Chain) via the limit order book mechanism. Since late 2022, the advent of blockchain technology has enabled On-Chain trading on decentralized exchanges (DEXs).
BTC Open Interest | Source: CoinGlass
On-chain options are executed through blockchain-based smart contracts. They operate without intermediaries for clearing and matching, offering a new paradigm in the crypto ecosystem.
On-chain and Off-Chain exchanges offer distinct pricing, fees, and decentralization advantages. Recent studies by various institutions have suggested that well-designed DEXs could save investors billions annually through improved risk-sharing for liquidity providers and reduced price impact for liquidity takers.
A Strategic Look Towards The Onchain Option Trading
– Functioning of Decentralized Options Trading: Decentralized options trading leverages Automated Market Makers (AMMs), like the Lyra protocol, which operate as smart contracts on Ethereum Layer 2 solutions such as Arbitrum and Optimism. Unlike traditional exchanges where market makers set prices, AMMs passively provide liquidity by underwriting options, with prices determined by supply and demand dynamics. The AMM adjusts the implied volatility (IV) based on the demand for different option types, strikes, and maturities, ensuring efficient pricing.
– Implied Volatility (IV) Differences: On-chain options generally exhibit higher IV compared to their Off-Chain counterparts. For Example, On-Chain IV for Ethereum (ETH) options with 30 days to maturity is almost 20% higher on average than for the same options traded Off-Chain. This discrepancy widens with increasing option maturity and options closer to being at the money. The higher IV on DEXs is attributed to the decentralized nature, which aligns with cryptocurrency principles, and the absence of counterparty risk. It is particularly relevant after the FTX collapse and ongoing regulatory issues with centralized exchanges.
– Trading Strategy and Profitability: A trading strategy involving selling high-IV options On-Chain and buying low-IV options Off-Chain can be implemented to exploit the IV difference. This strategy, potentially reflecting an “On-Chain risk premium,” can show strong performance, with profitability linked to the price and the market’s Fear & Greed index. Higher prices indicate future profit expectations, while higher returns during periods of market fear suggest a demand for higher compensation for increased risk.
– Impact of Fees and Trading Volume: The fee structure in On-Chain trading, including Delta Fees and Vega Fees, significantly influences IV. A high Vega Fee and Option Price Fee lead to an increase in IV, while the bid-ask spread in Off-Chain trading has a lesser impact. Additionally, trading volume affects IV more persistently On-Chain than Off-Chain, particularly for puts.
– Net Buying Pressure (NBP) and IV Dynamics: Retail investors who prefer out-of-the-money calls significantly impact IV. On-chain, NBP influences IV across all moneyness levels of calls and deep out-of-the-money puts, while Off-Chain, NBP affects mainly at-the-money calls and deep out-of-the-money puts. That indicates retail investors’ substantial role in shaping On-Chain IV.
Conclusion
The emergence of decentralized options trading is one of the significant innovations in the blockchain. On-chain options offer distinct advantages over their centralized options in terms of decentralization, risk management, and accessibility. As the crypto market grows, understanding the dynamics of On-Chain and Off-Chain IV, the impact of trading volume and fees, and the role of retail investors can play a crucial role in the future.
Disclaimer
The views and opinions stated by the author or any people named in this article are for informational purposes only. They do not establish financial, investment, or any other advice. Investing in or trading crypto or stock comes with a risk of financial loss.
Adarsh Singh is a true connoisseur of Defi and Blockchain technologies, who left his job at a “Big 4” multinational finance firm to pursue crypto and NFT trading full-time. He has a strong background in finance, with MBA from a prestigious B-school. He delves deep into these innovative fields, unraveling their intricacies. Uncovering hidden gems, be it coins, tokens or NFTs, is his expertise. NFTs drive deep interest for him, and his creative analysis of NFTs opens up engaging narratives. He strives to bring decentralized digital assets accessible to the masses.
