How Bitcoin Derivatives Could Curb Bitcoin Volatility

Whether one is a bitcoin bull or a bitcoin bear, the undisputable fact of bitcoin is that it is, compared to other assets, extremely volatile. It’s part and parcel a young experiment in the free market. It’s also a feature of bitcoin that makes investors wary of getting too involved. The knee-jerk answer to making bitcoin less volatile is to institute tighter regulation, possibly with some sort of central authority to regulate its price. That, of course, flies in the face of its decentralized ethos. But could bitcoin become less volatile through the free market?

It could if there existed an options market that could shave the harshest edges off of its wild price swings. But at the same time, it would take a player with pretty deep pockets to set up that exchange, and that so far hasn’t happened.

With that in mind, I talked with Equities.com’s Quantitative Research Analyst Nicholas Bhandari about the possibilities of a bitcoin options market. We discussed how it would work, what effect it would have on bitcoin's volatility, and what’s stopping it from coming to fruition.

Jacob Harper: In the last week alone, bitcoin dropped 20 percent, then rose 20 percent, then dropped 10 percent again. You’ve talked before about how allowing people to essentially bet on that volatility could decrease that volatility. Could you describe how that works?

Nicholas Bhandari: Any strategy, any anomaly in the market that creates profit, is priced out of the market over time. Currently there is no way to profit off of bitcoin’s volatility. You can buy an asset, but at this stage you have pretty much a 50/50 chance on whether it will go up or down. One of the advantages of options is that you can create strategies that profit off of volatility whether it goes up or whether it goes down.

JH: Because all an investor right now can do on bitcoin is go long.

NB: Precisely. You had mentioned in an earlier conversation that there is a short market, but it’s not well developed. If you could maintain an options strategy, and more people flood into that strategy, you could take some of the massive buying and selling out of bitcoin and have people focus more of their money on the options surrounding it.

As more and more people flood into an options strategy, it becomes less and less profitable over time. Because people are foreseeing volatility and buying options to protect against it.  And then volatility begins to decrease. And on top of it, if you have a strong option market around bitcoin, people can protect against that volatility, as options are effectively a form of insurance most of the time. So on one side, you have the option to protect against volatility so it’s not as crazy a thing anymore, where people aren’t as likely to buy and sell en masse. Two, people can profit on that volatility. It brings a stabilizing factor to the market.  

Frankly, it wouldn’t be that difficult to create a derivatives market around bitcoin. First, I can pretty much guarantee that a lot of people would be interested in it. Second, it would bring more institutional money into the market, which would have a calming influence.

JH: We have the Winklevoss Twins, who have tried to start a bitcoin ETF, allowing people to play the bitcoin market by proxy. But what are the roadblocks that are preventing something like a derivatives market from springing up around bitcoin?

NB: The short answer is: I’m not really sure. I think that a lot of the money in bitcoin right now is “uneducated” money. Having institutions flood into an asset isn’t always a good thing, but it does bring some sophistication. I think the reason a bitcoin derivatives market hasn’t happened is that there isn’t enough of a reason for institutions to even move into the market.

It’s sort of a catch-22. Options and securitization could bring stability to the market. But no one is willing to step in and do that because it’s too volatile. That weird issue has been the problem. It might even be more likely that some other cryptocurrency that has that built into it before they release it to the market is a more likely scenario of that occurring.

JH: When you say “built in,” how would that cryptocurrency be built differently? To minimize the ease of people being able to get in and out of it?     

NB: Like for equities, there’s a separate exchange that runs and operates all the options transactions. If you build a cryptocurrency with a separate exchange built at the same time to handle all derivative transactions on that cryptocurrency, so you build them up together, you could create a much more stable currency.