Ether call options look attractive relative to Bitcoin as the volatility spread narrows

Cryptocurrency trading is quite challenging right now, as the market is caught between conflicting issues at crypto-friendly bank Silvergate, operational bottlenecks at major exchanges, and optimism about Ethereum’s impending Shanghai upgrade.

Per crypto service provider Matrixport, the best way to navigate the melee is by setting relative value trades – a strategy for trading one or more securities relative to another.

“It’s time for relative value trades. Traders can now buy call options on ether and finance them by selling calls on bitcoin with a fairly strong profit potential,” said Markus Thielen, head of research and strategy at Matrixport, in a note to clients on Tuesday. “This allows traders to buy a high volatility asset (ether) at the price of a lower volatility asset (bitcoin).”

Options are derivative contracts that give the holder 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, while a put option gives the right to sell.

Buying a call/put option is akin to buying insurance against bullish/bearish moves. The buyer compensates the seller for offering protection by paying a premium while taking the trade.

Matrixport’s proposal involves collecting a premium by selling a bitcoin (BTC) call option and using the same to fund the purchase of an ether (ETH) call option.

The trading idea is based on the assumption that the spread between the annual 30-day realized or historical volatility of ether and bitcoin would bounce from the current unusually low level. That, combined with the upcoming Ethereum Shanghai upgrade, would make ether calls more expensive relative to bitcoin calls.

“The volatility spread between ether and bitcoin has compressed below 1. This has only occasionally happened and the spread has traded above 1 in 93% of observations over the past four years,” Thielen noted.

Volatility is mean-reverting and has a positive impact on option prices. In other words, periods of unusually low volatility are followed by increased price turbulence, which in turn increases the demand for options, making them more expensive. Thus, traders tend to buy options when volatility is lower than its long-term average.

The spread between ether and bitcoin realized volatility measures looks understated by its historical standards and could significantly reverse as we enter the Shanghai upgrade, which is expected to bring price turbulence.

“The spread has averaged 1.39 over the year and offers great risk/reward potential here,” Thielen noted, explaining the rationale behind buying ETH calls by selling BTC calls.

The Shanghai Upgrade, a backwards-incompatible hard fork coming sometime in the coming weeks, will open the withdrawal of ether that has been staked in the Ethereum network since December 2020. The upgrade will reduce the risk of stakes and increase capital efficiency, opening doors for more investor participation and perhaps ether price gain.

“A wave of new entrants who had previously watched from the sidelines could potentially add a level of buying pressure to ETH, especially if institutional capital can be lured,” Binance Research said in a report last month.