Understanding the correlation between bitcoin’s market value and implied volatility

Understanding the correlation between bitcoin’s market value and implied volatility

The positive correlation between bitcoin’s market value and its implied volatility means faster price appreciation for call option holders.

Crypto options exchange Deribit’s forward-looking bitcoin volatility index (DVOL) offers clues about the market’s expectations for price turbulence over the next 30 days, just as CBOE’s volatility index, VIX, does for equities.

A key difference has emerged this year. While the VIX continues to serve as Wall Street’s fear gauge, rising during bouts of risk aversion, the DVOL has developed a positive correlation with the cryptocurrency’s price. The 30-day correlation coefficient between bitcoin’s price and the DVOL index flipped positive in early January and rose to a high of 0.85 last week. At press time, the coefficient was 0.72. That has made call options tied to bitcoin more attractive than ever, according to observers.

“Since the start of 2023, bitcoin has displayed a strong spot/implied volatility regime of positive correlation. That has flipped 2022 on its head,” Greg Magadini, director of derivatives and crypto data provider Amberdata,. “It’s been rewarding call buyers with directional spot gains and increasing volatility gains.”

DVOL’s Positive Correlation With Bitcoin’s Price

DVOL, introduced in early 2021, measures bitcoin’s 30-day implied or expected volatility using Deribit’s options order book. The VIX is based on the options prices of the S&P 500 stock index.

Options are derivative contracts that give the purchaser the right, but not the obligation, to buy or sell the underlying asset at a predetermined price on or before a specific date. A call option gives the right to buy, a signal the holder has a bullish stance, while a put option gives the right to sell. Options prices are determined by several factors, including market direction as well as implied volatility, which is influenced by the supply and demand for options.

DVOL’s positive correlation with the cryptocurrency’s price means call options stand to benefit from both favorable directional movement and an uptick in implied volatility. In other words, calls are likely to see faster price appreciation during bullish moves than puts during bearish moves.

“Assuming the spot/vol correlation persists, this raises the appeal of owning calls as a call buyer can hit a ‘double whammy,’ winning on both Delta [directional gains] and Vega [implied volatility gains] in a sharply rising market,” Spencer Hallarn, an OTC trader at a crypto trading firm and liquidity provider GSR,

Caught Off Guard

The positive correlation is in stark contrast to last year, when bitcoin’s turn lower after an 18-month bullish trend caught traders off guard, leading to panic buying of put options. At the time, DVOL spiked during notable price declines and puts saw faster price appreciation during bearish price action than calls during corrective rallies.

CBOE’s VIX index rises during bearish market environments and falls or holds steady when the market rallies. That’s because stock traders tend to be long-term bullish and are quick to snap up puts for protection on the first signs of weakness in the equities market. Demand for protection dissipates when the market rallies, leading to a decline in the VIX. The net effect is that puts see faster appreciation in value during market swoons than calls do during risk-on trends.

Bitcoin’s Rally Fuels DVOL’s Positive Correlation

The recent surge in the price of Bitcoin has also sparked renewed interest in cryptocurrency trading, with options exchanges such as Deribit reporting record volumes. This has made it easier than ever for traders to buy and sell call options tied to Bitcoin, giving them greater flexibility in how they express their bullish views.

At the same time, the positive correlation between DVOL and Bitcoin’s price has encouraged more traders to use options as a means of hedging against potential downside risks. By purchasing put options, traders can limit their losses in the event that the cryptocurrency experiences a sudden downturn, while still allowing them to benefit from any further upside potential.

However, some experts caution that the current market environment may not last forever, and that traders should be prepared for potential changes in the correlation between DVOL and Bitcoin’s price. “Markets are dynamic and ever-changing,” noted Hallarn. “We can’t expect that the positive correlation will last forever, so it’s important for traders to stay vigilant and be ready to adjust their strategies as needed.”

Despite the potential risks, the current market dynamics offer significant opportunities for those who are willing to take a bullish stance on Bitcoin. With the cryptocurrency expected to experience further price gains in the near term, call options could provide traders with a lucrative way to capitalize on the rally, while also limiting their downside risks.