Approval of BTC ETF IBIT Options under BlackRock: What Impact Does It Have on Bitcoin and How to Arbitrage

Overview:

The approval of IBIT options by the SEC is a watershed moment for Bitcoin, as options can significantly enhance liquidity.

Options trading on IBIT will unlock new capital pools, allowing institutional investors to confidently participate in BTC investments while reducing downside risk.

IBIT's dominant position in the Bitcoin ETF field will be accelerated, providing access to the spot market and the flexibility of options trading.

I discuss the reflexivity of gamma squeezes and how they impact the price of BTC in rational expectation models.

The approval of IBIT options solidifies BTC's position as a major asset.

On Friday, September 20, 2024, the U.S. Securities and Exchange Commission (SEC) approved the listing and trading of iShares Bitcoin Trust ETF (NASDAQ stock code: IBIT) American-style options. The approval by the SEC means the most challenging part may have ended, although approval from the U.S. Office of the Comptroller of the Currency (OCC) and the U.S. Commodity Futures Trading Commission (CFTC) is still required. The listing of IBIT options will be a watershed moment for Bitcoin (BTC-USD), with its impact potentially greater than the approval of spot ETFs in January. This article will analyze the consequences of this development and expand on some Bitcoin options strategies currently available to most U.S. investors.

Background

U.S. investors have essentially been unable to access any decent quality BTC options. The leading BTC options trading venue has been the options exchange Deribit, based in Panama. Deribit supports 24/7/365 trading of BTC and ETH options, as well as perpetual futures products for some major cryptocurrencies. The options are European-style and settled in the underlying cryptocurrency. Deribit users can utilize portfolio margin and leverage, similar to the capital efficiency provided by the SPAN margin in traditional financial markets (read: something you can get from Interactive Brokers). Due to being limited to cryptocurrencies, Deribit users cannot cross-margin their collateral with assets from traditional portfolios such as ETFs and stocks. Deribit is only available to U.S. citizens.

U.S. investors can access LedgerX, a CFTC-regulated cryptocurrency options exchange. However, LedgerX's functionality is quite limited. Firstly, the bid-ask spread on LedgerX is very large. Secondly, there is no portfolio margin available. While Deribit users can trade naked options, each call option on LedgerX must be sold in a covered manner (holding the underlying BTC), and each put option must be sold for cash (the cash value of the strike price).

Another possibility for U.S. investors is trading BTC futures options. For example, /BTC and /MBT are BTC futures traded on the CME. These products have their own options on futures. However, their bid-ask spreads are also very large. The regulatory fees for futures options are often much higher.

The last option for U.S. investors is to trade options on assets related to BTC. MicroStrategy options could be used as an alternative. Another option is BITO options. However, the issue is that both MSTR and BITO have suffered significant tracking errors from BTC, despite their very high daily correlation.

For years, the lack of a truly satisfactory BTC options trading venue can be said to have suppressed the adoption of BTC. Most well-known assets have deep options markets. SPY, QQQ, and IWM all dominate the market in terms of options trading volume with daily expirations. There are also SPX and XSP index options, which have extremely strong liquidity. The liquidity of HYG, SLV, GLD, and TLT options is lower compared to major U.S. stock indices and their ETFs. The trading volume of these options is also very high. A complete list of ETF trading volume breakdowns can be found in this tracker. Each of the seven tech giants has a very deep options market. The key is that having liquid options is an undeniable sign of asset credibility.

From another perspective, the market value of BTC is comparable to that of silver. However, the U.S. market does not offer any BTC options chains slightly similar to SLV options. Therefore, the approval of IBIT options is a huge credibility marker, giving BTC a very prominent position among all assets.

Impact 1: Liquidity from Options Traders

The first significant impact is that options will create more liquidity for the underlying asset as options traders (i.e., market makers) engage in dynamic hedging strategies. When trading options, traders often hedge their risk exposure by buying or selling the underlying asset (in this case, BTC or IBIT ETF shares). The continuous buying and selling by options traders provide stable trading flows, smoothing price fluctuations and increasing overall market liquidity. The resulting liquidity not only benefits traders seeking smaller spreads and deeper order books but also helps stabilize the market, especially during periods of high demand or increased volatility. One impact of this increased liquidity is that it allows larger capital pools to enter the market while reducing slippage.

Impact 2: Tactical Hedging Unleashes More Liquidity

The launch of IBIT options will unlock a new capital pool that was previously hesitant to enter the BTC market due to risk management issues. Institutional investors, especially those managing large portfolios, often require complex tools to hedge their positions before committing significant capital. Through tactical hedging strategies using IBIT options, these investors can participate more confidently in BTC investments while reducing downside risk. This ability reduces perceived barriers to risk and allows more capital to flow into the market. As these new entrants use IBIT options to hedge and protect their investments, the cumulative effect will significantly increase liquidity, further solidifying BTC's position in global asset allocation.

I want to emphasize the importance of this point. You will see that many institutional investors manage large portfolios with very specific requirements for risk management, purchasing power, and leverage. So far, many of them have remained cautious about BTC because spot ETFs alone cannot solve the problem, and real BTC certainly cannot solve the problem. Options like IBIT, which are marginable securities, are a perfect complement to bring margin investors into Bitcoin.

Firstly, many institutions can now hold Bitcoin ETFs and then use their accumulated portfolio purchasing power to establish tactical option hedges for ETF positions. Secondly, many institutions can choose to completely ignore spot ETFs but use IBIT options to construct very precise risk-defined returns based on BTC price movements. Now, recall Impact 1—all of this derivatives trading volume comes from options traders, many of whom will touch the spot market to hedge the options they are trading. Therefore, the increase in liquidity comes from many different aspects, some of which are self-referential and highly reflexive.

Thirdly, consider all the covered call option funds we have now, which generate income while holding assets. With the approval of IBIT options, funds can finally earn income similar to QYLD, MSTY, TSLY, TLTW, but for BTC. Covered call option fund managers can hold IBIT and then sell out-of-the-money (OTM) call options on IBIT weekly or monthly for about 5%. Given BTC's huge IV, this could generate significant income. This is another example of options directly opening more doors to liquidity, as the list of things that can be done through options has now expanded.

One last point worth noting is that options may be the most important derivative as they can be used to construct all other positions. Want a futures contract? That's buying a call option and selling a put option, both with the same strike price and expiration date. Want to bear volatility without direction? That might be a straddle: buying a call option and a put option with the same strike price and expiration date. In short, options can create very complex structured products, all of which help to bring more institutional capital into BTC. A very feasible example might be BTC-backed loans. As a financial institution, if I can find an effective way to hedge BTC-related risks, I might offer BTC-backed loans. That's how structured products work! These are typically created by purchasing specific option baskets.

Impact 3: IBIT's Dominance Will Only Accelerate

As more and more investors flock to IBIT to take advantage of options, I believe its dominance in the Bitcoin ETF field will sharply accelerate. The ability to trade options will make IBIT a more attractive tool for those seeking to invest in Bitcoin with a broader range of strategies. By providing access to the spot market and the flexibility of options trading, IBIT will stand out from other spot ETFs.

At the simplest level, IBIT holders can now earn income through covered call options without using any purchasing power. If you hold FBTC, for example, you can only sell IBIT call options by using your purchasing power. This reduces your capital efficiency because it means you cannot use that purchasing power in other trades.

As IBIT is the first company to receive options approval, even if options for other spot ETFs are approved, IBIT's options trading volume may remain "stable". The capital flowing into IBIT may far exceed that of other competitors, thereby consolidating its position as the preferred Bitcoin ETF. The rise in IBIT's dominance poses some long-term risks, but I will discuss these risks in the risk section.

Impact 4: Reflectivity in the Market Reaches Unprecedented Upside Due to BTC's Absolute Scarcity and Option Greeks Dynamics

This issue is very complex. I think it's best to first discuss the short squeeze on GME in January 2021, and then discuss why squeezes for any asset fundamentally cannot be sustained. Finally, we will discuss why BTC is different and how these choices will affect the future valuation of BTC.

What happened to GME in January 2021 was not just a short squeeze. Perhaps more importantly, it involved the use of weekly call options, leading to a gamma squeeze. These options had very short maturities (less than 14 DTE), meaning they had huge gamma. Gamma is the second derivative of the option price with respect to the underlying price. In other words, it is the convexity of the option price with respect to the underlying price. Gamma is one of the main reasons options traders hedge "dynamically". As the price of the underlying asset changes, it will change the delta of the option through gamma. A gamma squeeze is a phenomenon where directional traders buying short-term OTM call options lead to dealers having severely negative delta and gamma. To hedge the risk, dealers go out and buy stocks until they are delta neutral. However, unless offset by buying more options, the negative gamma will remain on the dealer's books. As the price of GME rises, possibly due to the initial dynamics of the short squeeze, OTM call options become closer to ATM. ATM options are actually where gamma is highest. Therefore, from the first stage of the rebound of GME, many negative gammas inflated to larger magnitudes. At this point, every incremental increase in the price of GME forces a larger incremental change in delta (remember, delta is determined by gamma). This forces dealers to buy more GME, as many options are close to ATM. But this buying, of course, pushes up the price, leading to more and even further OTM options approaching their ATM price and reaching their maximum gamma. Even as the call options become ITM, the dealer-driven buying does not stop. As the call options further become ITM, gamma decreases, but it is still positive for long options, meaning delta continues to increase. The driving force of continuously increasing negative delta is what compels dealers to continue buying stocks.

This is a gamma squeeze, which occurs when directional traders buy a large number of call options. It should be clear that directional traders did not plan to trigger a gamma squeeze. Gamma squeezes often occur naturally when prices rise (possibly due to a short squeeze), as traders seek short-term upside opportunities and buy expiring call options.

So, why do these squeezes not continue, and why do stocks that are squeezed often fall back to their pre-squeeze levels? The answer is not actually "fundamentals cannot justify this higher price point". Remember, if we base fundamentals on the long-term average of the price-earnings ratio, then fundamentals cannot justify most price points today. The answer to all price changes always comes down to supply and demand.

Sudden and parabolic price increases almost always result from sudden and parabolic growth in demand. When prices rise to such high levels, it signals to producers of all underlying assets to start producing more supply to meet this demand. This is what drives down prices. When stocks experience a gamma squeeze, companies issue more stocks and sell them to the market. This is exactly what happened with GME, AMC, and other meme stocks that surged in 2021. Even with sharp price increases in commodities, you can bet that producers of commodities are now working overtime to meet demand. When Russia imposed sanctions, the price of natural gas rose. Natural gas producers around the world also started producing more natural gas, which clearly increased supply and brought natural gas prices back to pre-sanction levels. The charts accurately show what happened.

The reality is that every commodity, stock, bond, currency goes through this dynamic. If prices are indeed very attractive to producers or issuers, more supply is created to meet demand. There is only one major asset that deviates from this rule: Bitcoin.

Bitcoin has only 21 million coins. This is a programmed fact that cannot be changed unless all nodes, miners, and users agree to switch to another code to manage the Bitcoin network. This consensus change is basically impossible. Therefore, Bitcoin is absolutely scarce. Linking it to options, if IBIT experiences a gamma squeeze, there will be no elastic supply to generate more BTC. The only sellers will be those who already own BTC and are willing to trade at a higher dollar price. But this brings a big problem—selling into the momentum doesn't make much sense because everyone knows that more BTC will not suddenly be created to meet this demand that is driving down prices. And this fact will affect all decisions related to the situation. I just want to clarify. I'm not saying no one will sell BTC. What I mean is that when you compare BTC holders to GME holders, both have their assumed gamma squeezes, and one clearly has more incentive to sell because they know more supply will be created, driving down prices. This comparison applies to any asset holder compared to BTC holders. Silver or oil holders know that more supply is coming, not from other holders, but from miners and drillers extracting it from underground.

So, if IBIT options are listed, there is now the possibility of a truly massive and sudden gamma squeeze rebound. Furthermore, due to Bitcoin's absolute scarcity, this rebound is more likely to last longer than rebounds for other assets. This is now a factor that should be reasonably included in the BTC valuation model. Since the probability is positive, the additional boost to the expected value must also be positive. This constitutes sustained growth under a rational expectation model for BTC prices.

Operational Options Trading

I believe the biggest benefit for retail investors is that they can now participate in the famous volatility of BTC. The annualized volatility of BTC is 50-100. This is many times higher than the volatility of SPY or QQQ. It is much higher than the volatility of GLD or SLV, and sometimes definitely more than 10 times higher than TLT or HYG. Of course, the best measure of BTC IV currently comes from the best place for BTC options: Deribit. This is the time series of BTC DVOL.

DVOL stands for "Deribit Volatility". The DVOL method is essentially the same as the VIX method. Both use two options closest to a 30-day expiration, discard some illiquid contracts, and use the variance swap formula to calculate model-free implied volatility (i.e., not influenced by the Black-Scholes model). Compared to the VIX, which is currently below 17, typically around 12, the current reading of DVOL is lower. The existence of Bitcoin options in the form of IBIT options allows American investors to enter the world of BTC IV. If done correctly, this could lead to substantial returns.

The simplest trade is cash-secured put options or naked put options. Essentially, selling put options within the 40-25 delta range is all that is needed. With the long-term bias of BTC rising, put options are a way to earn a premium to buy potential future declines. If BTC continues to rise, you can keep the entire premium. You can also be more aggressive with put options and sell at the money (ATM) options. This will result in a larger premium. I have never seen a backtest of continuously selling ATM BTC put options, but backtests of doing the same with SPX put options look quite impressive. For IBIT put options, I think this is due to the much higher IV of BTC.

Personally, I am considering combining short OTM put options with multiple long OTM call options. This will create an "enhanced" futures position, where the upside becomes more convex, approaching multiple 100-share IBIT stock positions, while the downside falls to just a 100-share long position in IBIT stock. Since the IV of put options is often higher than that of call options, sometimes you can short one put option and buy two call options without any debit.

Risks

There are several risks worth mentioning. First, all of this depends on whether BTC can continue to gain broader adoption and acceptance as an asset. A significant drop in BTC price could make this point irrelevant. But this risk is actually synonymous with repetition.

As IBIT's dominance continues to grow, I believe the tail risk lies in Coinbase, as the custodian, becoming one of the largest honeypots in history. Personally, I have held FBTC in my retirement account because Fidelity is custodian of the BTC. Can I switch to IBIT so I can now sell covered call options? Maybe, but personally, I am not very interested in covered call options. The approval of options is likely to increase the size of the Coinbase honeypot at a faster pace.

Another tail risk I can see is related to BTC trading 24/7 throughout the year, while IBIT and IBIT options only trade during traditional market hours. My concerns have two aspects.

First, I would be very cautious about holding short volatility positions in IBIT over the weekend, as it is impossible to close out when BTC fluctuates 15% within 6 hours on a Saturday. Technically, significant problems may occur even outside of weekends. Overnight short volatility positions also carry high risk, as BTC may fluctuate 15% at any time between 4:00 PM Eastern Time and 9:30 AM Eastern Time, and you cannot close out. Stop-loss is a good choice for normal options trading. When I trade SPY options, I set stop-loss. But they are effective because SPY never trades when my options are not trading. This is not the case with BTC and IBIT options.

Second, I am concerned that the options market may produce extreme situations, which could lead to random high volatility in BTC and possibly accompany IBIT experiencing a collapse in net asset value. I am not sure how this will develop, but I think the very high gamma value of IBIT at the close of the market on Friday may force dealers to buy real BTC to hedge their delta over the weekend. Now, there may be some risk in transferring real BTC to IBIT stock due to IBIT's cash redemption. All of these risks could ultimately spread to the BTC market. We may randomly see bid-ask spreads widen, and order book depth thin out due to significant events.

Conclusion

Overall, I believe the approval of IBIT options is an extremely important moment in Bitcoin history. It further solidifies the position of BTC and major assets. It opens the door to more liquidity. It brings a variety of interesting new possibilities for investors proficient in derivatives.

I have always believed that the impact of a Bitcoin ETF is not as significant as people imagine. Most of the inflow of funds is related to underlying and paired trading, not to bullish views on the asset. However, introducing options on the largest spot ETF may greatly change this dynamic. As I have outlined here, the versatility of the liquidity options chain triggers bullish sentiment in the classic reflexivity of the market. Liquidity brings more liquidity, and optionality brings liquidity that has always been on the sidelines—all of which will bring more liquidity. Now they have a complete set of tools for fine-tuning and capital-efficient hedging, most of which will continue to exist in this liquidity.

BTC and IBIT are worth buying. Options are a watershed moment, and we are still 14% below the all-time high, and just beginning a rate-cut cycle. The macro situation is absolutely great.

The above content is from Stony Chambers Asset Research

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