The Puzzles of Bitcoin Options for Ordinary Investors

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The landscape of Bitcoin investing is littered with peculiarities. One of the oddest is the bizarre trade in options on Bitcoin equities.

Bitcoin Equities

Several Bitcoin securities exchanges enable investors to buy and sell shares in Bitcoin businesses and even in a few non-Bitcoin businesses which have turned to the Bitcoin markets to raise cash. (Of the latter, Australian mining company Kenilworth Exploration is probably the best known example.)

When an ordinary investor — by which I mean someone who has spent some time investing elsewhere than in the Bitcoin economy’s brief childhood — encounters one of these exchanges for the first time, one of the first things they’ll notice is the lack of a single bid/ask quote for a given security. Instead, they’ll find an entire order book of bids and asks, with differing prices and assorted sizes. As I touched on in an article about Bitcoin derivatives a couple of months ago, in the absence of one or more individuals or institutions willing to step up and act as counterparty to all trades, there’s little else that Bitcoin trading platforms can do: they maintain an order book of bids and asks and wait for something to match up. (See “Bitcoin Derivatives, Liquidity and Counterparty Risk”.) This will be a little unfamiliar to ordinary investors, but most people aren’t going to find what amounts to a list of open orders to be too difficult to understand.

In a system that lacks market makers, ordinary investors will see how it makes sense for individual stocks to be traded like this, with the whole order book laid out with the equivalent of a slew of open orders at different price points. In this sort of environment, it makes sense for an investor to decide, maybe minutes or hours or perhaps even days in advance, that they’d be happy to buy stock of Company XYZ at a price of 5, and to queue that order to be filled whenever the price of Company XYZ drops to 5. This is no different than entering an ordinary limit order (in this case, a GTC, or Good-Til-Cancelled, order).

So far, so good.

Options on Bitcoin Equities

But now take a look at options on individual securities, and here’s where things start to become a little alien. The first obvious difference between Bitcoin equity options and standardized equity options listed on normal exchanges is the absence of standardization. Look through an exchange like BTC-TC and you’ll find a higgledy-piggledy list of various options being offered. There’s a fixed set of expiration dates, but strike prices, premiums, and number of underlying shares are determined independently by each option writer. The situation is similar on BitFunder, although there the expiries vary too. It’s almost as if someone had first built an ECN-style platform for equities and then thought to themselves hey, why don’t I just do options this way too?

Setting aside the lack of standardization, an ordinary investor could still, at a stretch, try to make some sense of this sort of person-to-person order book for options. They could draw an analogy with orders for ordinary listed options being routed directly to specific market makers via Level II quotes.

They might think that would make some sense, but they’d be crazy wrong.

As I described above, it’s perfectly reasonable for an investor to enter a limit order on a stock at a given price. But what emphatically does not make sense in an environment without market makers is trading options that way.

Options are, by definition, derivatives, whose values are linked to the price of an underlying security. In normal non-Bitcoin investing, the prices of options and their underlying entity move in tandem, and market makers/specialists act as guaranteed buyers/sellers, populating all the strike prices in a series with constantly updated bids and asks appropriate to each. Ordinary investors using limit orders for options in this environment know that if the option price hits their limit, the market maker will fill the order. They also know that option prices themselves will move relatively predictably along with changes in the underlying entity, within an amount of ‘wiggle room’ created by changing implied volatility.

However, traders hanging open option offers out there on a Bitcoin-based trading platform are not in a role like that of an ordinary investor placing a limit order and relying on market makers to keep things orderly; they are taking on a role analogous to that of the market makers themselves, minus the rational attention to price. To put it differently, traders just hanging an open option offer out there and leaving it, with no involvement from market makers, have no idea whatsoever what a rational price might actually be for the option if and when the offer is taken, because they have no idea what the price of the underlying entity will be by the time it happens. (And although you might think that anyone placing option offers would be super-attentive, constantly revising them to reflect changes in the underlying, this is not the case; nor does the design of the trading platforms make it at all efficient to do so.)

As a result, traders with open option offers can wind up literally giving away free money when the price of the underlying security moves against them. Maybe this is one reason why many of the individual equity options on Bitcoin-denominated exchanges wind up being offered with implied volatility in triple digits.

It’s Not Just Exchanges…

It’s not just Bitcoin-denominated trading platforms; here’s an example from outside an exchange. Not long ago, a user on the Bitcoin forum was trying to find someone to sell him calls on a certain underlying equity. At first glance, there’s nothing too unusual about that, as individual forum users and #bitcoin-otc users do sometimes enter into option agreements in a fashion analogous to the over-the-counter trading in non-standardized derivatives that takes place in the fiat world. (In the fiat world, this normally occurs between large financial institutions, market makers, or other well capitalized entities which, in addition to their significant financial resources, also bring significant competence in evaluating and managing counterparty risk.) But in this case, the user wasn’t just looking to buy calls, he was trying to convince other users that it would be a great idea to write naked calls — because, after all, that would mean they wouldn’t have to go to the trouble of owning the underlying equity!

This argument seemed pretty OK with everyone. Nobody mentioned that naked calls expose the call writer to unlimited losses as the price of the underlying entity rises.

As an aside, it’s worth noting that US brokerage houses typically restrict options trading based upon their assessment of an investor’s competence, experience, and capacity to absorb losses, and for that reason, naked call writing is strictly limited to the highest level accounts (Level 4 or 5, depending on the brokerage). Of course, many investors do write naked calls, despite the limited profit and unlimited risk. Speaking for myself, despite being allowed to do so, I have never even considered it, and all my own delta spreads and ratio spreads — in which more calls are written at the higher strike than are purchased at the lower — are overlaid on common stock already owned, ensuring the excess short calls are covered. But whether one chooses to do it despite the unlimited risk, or whether one regards it as mildly crazy, my point is that naked call writing is extremely risky and certainly never something to be done just because it’s convenient not to own the underlying stock.

Back to the forum saga: some time within a day or so, the user found someone to write the options and as a result returned to the forum to announce that the offer to buy the calls was no longer open. It was then that another much more senior user joined the fray to criticize the first user. I’ll paraphrase, but for full effect you can imagine this in the voice of Dr Cox from the TV series Scrubs: “Way to go there, newbie, leaving an option offer open for a whole day; could you possibly be any more of a pansy?” Not only was singing the virtues of naked call writing apparently entirely reasonable, but failing to leave an option offer open for more than a day was taken as a sign of cowardliness, inexperience, incompetence, or maybe all three.

At that point, ordinary investors reading the thread might easily have concluded they’d accidentally been transported into another dimension.

Reinventing the Wheel, and Coming Up With a Cube

I’m not saying that everything about options on Bitcoin-based exchanges or Bitcoin options negotiated between individuals should work just like their big brothers in the fiat investment world. But on the other hand, Bitcoin-based exchanges and individual investors could take a page or twenty from the established techniques that work exceptionally well in the fiat world and which successfully support trillions of dollars in volume. At the moment, it’s hard to avoid the impression that rather than figuring out how to leverage what is already known to work well and applying it to the Bitcoin context, many Bitcoin entrepreneurs and investors have instead decided to reinvent the wheel — and have come up with a cube. Sure, you can push a wagon on a set of four cubes, and you might get there in the end, but it sure isn’t going to work very smoothly. And the reason it isn’t going to work very smoothly is not that your wagon is underfunded or underdeveloped or that it just needs to get a bit more horsepower in front of it, or even that it needs more participants working with it; it’s that a cube is simply the wrong shape to begin with.

In the article which I mentioned earlier (“Bitcoin Derivatives, Liquidity and Counterparty Risk”), I focused primarily on hedging currency risk and the benefits that effective hedging would provide to the Bitcoin economy as a whole. A gaping hole still exists in the Bitcoin currency derivatives market, one waiting to be occupied by someone willing to provide a credible, efficient, liquid derivatives platform backed by competent market making and reliable clearing with limited counterparty risk. (None of the alternatives I discussed in the article fits the bill, and nor do those which I deliberately left out.) A similar opportunity is available in individual equity derivatives for anyone willing to step up: create a real market, with a reliable clearing house capability, with real market makers, and see volume and corresponding revenue explode. The CBOE of Bitcoin hasn’t been born yet, and nor has the OCC, but when they are — or, more likely, when a hybrid organization emerges to take on the roles of both — it will be both big news for Bitcoin investors and a potential gold mine for those who create it.

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