How to Trade Low Volatility

Despite the crypto market’s wild price swings in past it has been recently trading in a very narrow range. Newfound stability may be good for wider crypto adoption, but it still poses a question of how to trade volatility in the short term.

Unusual calm

Cryptocurrencies have been trading in a very narrow range since mid-September. The difference between Bitcoin’s highest and lowest value in a month is just about $2000.

Bitcoin

The historical volatility of Bitcoin (as measured by the BitMEX BVOL index) is near all-time lows. It is about 10 times lower than the 2018 or 2020 highs.

Bitcoin 30-day annualized historical volatility (BVOL index)

The shorter 20-day historical volatility of Bitcoin falls even below that of the stock market. According to Kaiko estimates, last Friday's 20-day rolling volatility declined below that of the S&P 500 and Nasdaq for the first time since 2020. “Bitcoin volatility is at multi-year lows while equity volatility is only at its lowest level since July,” Clara Medalie, head of research at Kaiko, told CNBC (see more at cnbc.com ).

Time to sell volatility?

Bitcoin implied volatility declines, but not as much as the historical one. The gap between implied and realized (historical) volatility is unusually high (although trading history is relatively short).

Bitcoin historical volatility (BVOL index, blue) and implied volatility (DVOL index, orange)

Volatility selling becomes very profitable because a trader effectively sells it at an implied price and “buys” (closes a position) at a historical price. That entices sellers of implied volatility since many option-focused research notes suggest selling the volatility. For example, in one of the latest weekly reviews, Genesis Volatility said “this is one of the best vol. selling environments for BTC”.

However, the market does not believe a low-volatility environment will remain for a long time. The volatility curve becomes very steep, as longer-dated volatility is much more expensive than short-dated one. The gap between 30-day and 7-day implied volatility is the highest ever (i.e., 30-day value minus 7-day value is the highest in trading history).

Bitcoin 7-day and 30-day at-the-money implied volatility

Although it’s a dangerous longer-term signal for volatility sellers, in the short-term the very high gap between 30-day and 7-day implied volatility makes volatility selling even more attractive, because it provides a high carry to volatility sellers. Instead of naked selling of volatility, a trader can sell 30-day volatility and hedge it with rolling 7-day volatility, earning a very high spread and being reasonably hedged against unexpected events (which usually affect short-term volatility more than longer-term one).

The stock market in 2017-2018

If volatility selling sounds too good to be true, it is. The current situation in the crypto market is much similar to that of the stock market in 2017. After a modest volatility splash in August 2017, the stock market entered an unusually calm period lasting from September 2017 to January 2018. VIX (the implied volatility of the S&P 500 index) was near historical lows and realized volatility was even lower. That ended abruptly in February 2018.

VIX in 2017-2018

The VIX curve was very steep at that time, enticing volatility sellers with a high carry. VIX itself did not change much during September 2017-January 2018, but constant rolling over short-volatility exposure earned a lot. Volatility selling, which is usually a niche strategy used by advanced traders only, became popular even among retail investors (probably because they do not fully understand the risks of this trade). Selling volatility during that period was a highly successful strategy for as long as several months, earning about 10-15% per month if executed via an ETF. The relevant ETF, ProShares Short VIX Short-Term Futures ETF (SVXY), rallied by 77% from September 1, 2017, to its high on January 11, 2018.

The end of the volatility selling trade of that period was fast and furious. Large-scale liquidation of short-volatility positions was met with limited liquidity, slaughtering prices in the process. The ProShares Short VIX Short-Term Futures ETF (SVXY) fell as much as 90% during the first week of February 2018. Even early adopters of the volatility-selling strategy lost most of their investments. That event becomes famous and is often called “Volmageddon”.

ProShares Short VIX Short-Term Futures ETF (SVXY) in 2017-2018

Practical advice from that story is a possible market timing signal to turn long volatility. VIX curve inverted before the “Volmageddon” and stayed inverted for some time, forcing volatility sellers to start closing positions because of a negative carry.

Conclusion

Extremely low realized volatility and a very steep volatility curve entice sellers of implied volatility. That may work for some time, but it requires very strict risk management and it’s for very advanced investors only. Volatility selling seems to be easy money when it works, but its most likely eventual outcome is to lose most if not all investments.

If a stock market analogy holds, volatility curve inversion may be a useful market-timing indicator. At the very least, I recommend closing all short-volatility positions if the inversion holds for a few days. Still, the trade I like is to enter long-volatility positions when sustainable inversion occurs.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.