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The world of cryptocurrency trading has expanded beyond just buying and selling digital assets.
Today, crypto enthusiasts and professional traders alike are increasingly exploring options trading to diversify their portfolios and manage risks more effectively.
Understanding the concepts of implied and historical volatility is crucial for anyone venturing into crypto options, as these metrics play a significant role in determining option prices and making informed decisions.
In this article, we’re going to delve into the differences between implied and historical volatility in the context of crypto options trading. We’ll also discuss their connection to the Black-Scholes pricing model, a widely used method for valuing options.
Historical volatility, often referred to as realized or statistical volatility, is a measure of how much the price of an underlying asset has fluctuated in the past.
In the context of cryptocurrency options, historical volatility represents the degree of price variation experienced by a specific crypto asset, such as Bitcoin or Ethereum, over a certain time period.
Traders typically calculate historical volatility by analyzing the standard deviation of daily price returns for a chosen period. By examining past price movements, they can get a sense of the asset’s volatility and use this information to make informed decisions about future price movements and potential risks.
Implied volatility, on the other hand, is a forward-looking metric that represents market expectations of future price fluctuations for an underlying asset.
In crypto options trading, implied volatility is derived from the current market price of an option contract and provides insights into the anticipated volatility of the crypto asset over the option’s lifetime.
Unlike historical volatility, which is calculated based on past data, implied volatility is inferred from current market conditions and the prices of options themselves. As such, it can be viewed as a projection of future volatility that reflects the collective opinions of market participants.
The Black-Scholes pricing model is a key tool for valuing options contracts, including crypto options.
This model takes into account several factors, including the current price of the underlying asset, the option’s strike price, the time until expiration, the risk-free interest rate, and, crucially, the implied volatility.
Understanding the difference between implied and historical volatility becomes particularly important when using the Black-Scholes model, as the model relies on implied volatility as a critical input. By accurately estimating implied volatility, traders can decide whether an option’s premium represents fair value, and thus more accurately identify potential trading opportunities.
Understanding the nuances between implied and historical volatility can help traders to:
Pretty much all traders who use websites which provide crypto price data (such as CoinMarketCap, Trading View, and of course all crypto exchanges) will already be familiar with how to measure historical volatility — it’s all in the charts!
Many sites offer the ability to download the data in CSV files, and some provide APIs allowing developers to pull data into their own applications.
On the other hand, measuring implied volatility is slightly different because it isn’t based on historical data, and is instead derived from the market prices of options contracts.
Various models can be used to calculate implied volatility, with the most widely-used one being the Black-Scholes model, which uses several inputs to calculate the theoretical price of an option:
Since all inputs other than implied volatility are known or can be estimated, the model can be used to reverse-engineer the implied volatility by matching the theoretical price to the observed, current, market price of the option.
However, if you don’t fancy using mathematical techniques such as the Newton-Raphson or Bisection methods to do your calculations, you can also simply go and have a look at most options platforms which typically display implied volatility as calculated by their systems alongside options prices.
There are also a number of online Black-Scholes calculators which can be used to reverse engineer the implied volatility from the current market prices of options contracts.
Although at first glance many traders are confused by the differences between historical and implied volatility, it’s actually a relatively easy concept.
Whilst crypto hodlers love upside volatility — that is those large fast moves when prices push up — the downside can be more annoying.
Until now, preserving gains and minimising the impact on your wallet's value means using stop losses on an exchange, or buying puts from one of the various options platforms. Both of these methods have their downsides, and so we developed a completely new method of protecting your crypto from downside volatility — it’s called Bumper.
Bumper allows you to protect your tokens from market crashes, black swan events and general downside volatility. Just lock your crypto in the smart contract and set a floor and voila — you’re protected.
Should your position close, and the price of the asset you’re protecting is below the floor you exit with stablecoins to the floor's value, but if the price is above the floor, well then you simply retrieve your original asset.
In this way, Bumper functions kind of like a combination of insurance, a put option and a stop loss, but without the inherent downsides of each. Whether you're a trader who likes to be glued to their screen, or you prefer to take a more passive approach to investing in crypto, Bumper’s novel design allows you to simply and easily stop downside volatility from ruining your day.
Bumper is due to launch on mainnet in 2023, and you can stay abreast of developments by joining our Discord and following us on social media.
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