Weekly Commentary: Hedge Trimming

Last week’s selloff in spot prices caused a sharp spike in implied volatility and the highest funding rate paid by short perpetual swap positions to longs to short positions since March this year. Open interest data for BTC suggests that this was caused by the closure of liquidation of long positions, rather than an increase in demand for short exposure. If the move was exacerbated by the hedging activity of short options positions (as indicated by the all-time low levels of implied volatility that we have commented on over the past three months), then the closure of long positions in the perp contract market during a market selloff would imply the hedging of more short call positions than short put positions.

Volatility Spiked Sharply

Figure 1 Hourly 1-month tenor, at-the-money implied volatility for BTC (yellow) and ETH (purple) options since 24th May 2023. Source: Block Scholes

• Implied volatility awoke from its down-and-sideways trend late last week as BTC and ETH spot markets fell close to the $26K and $1.6K levels.
• This saw 1-month tenor options spike to their highest levels since June.
• The vols of both assets have since settled at a higher rate, with BTC and ETH just above and below 35% respectively.

Funding Rate Flipped

Figure 2 Hourly perpetual swap contract funding rate for BTC (yellow) and ETH (purple) as traded on Deribit since the 23rd July 2023. Source: Block Scholes

• The selloff saw the funding rate of the perpetual swap contract swing the furthest negative it has been since March of this year.
• Whilst the selloff would explain the negative direction of the funding rate, the magnitude of its downturn was likely exacerbated by hedging activities of short gamma positions.
• The ultra-low implied volatility that we had commented on prior to the move indicated high demand for short volatility positions who must sell when the market falls in order to remain delta neutral.

Position Closed Out

Figure 3 Open interest in the perpetual swap contracts of BTC (yellow) and ETH (purple) measured in US dollars since the 23rd July 2023. Source: Block Scholes

• The selloff in spot prices also saw the closure of many perpetual swap contract positions – more so in BTC than in ETH.
• This indicates that the switch in the direction of the funding rate was caused by the closure or liquidation of many long positions, rather than the opening of new short positions.
• If the move was indeed driven by the hedging of an options delta, then this would suggest that traders were mostly cutting back delta hedges of short call positions.
• This hypothesis is supported by the skew of the volatility smile towards OTM puts in the days before the selloff, showing a lower pricing for calls relative to puts.