Hedging activity of market makers, who are always on the opposite of investors’ trade, appears to have kept prices rangebound off late.
Bitcoin (BTC) and ether (ETH), the top two digital currencies by market price, have been unusually calm for over two weeks. The range play probably stems from the market running into competing narratives and influences.
There is another powerful force at work, an invisible hand of cryptocurrency options market makers, partly in charge of keeping prices rangebound, reports by observers.
Market makers are entities with a contractual obligation to sustain a healthy level of liquidity on an exchange. They secure there is enough depth in the order book by offering to buy or sell a call/put option contract at any given time.
For example, if a trader desires to buy a Bitcoin call option at the $40,000 strike price and there is no matching sell order, the market maker would do the needful by supplying the sell order. Options are derivative contracts that give the purchaser the right to buy or sell the underlying investment at a predetermined price on or before a specific date. A call option gives the right to buy, while a put option offers the right to sell.
Market makers, this is why, are always on the opposite side of investors and maintain a delta-neutral (direction-neutral) book by actively buying and selling the underlying investment in the spot or futures market as the price swings.
Stuffed with “positive gamma”
In recent weeks, investors have been shorting or writing call options or positive tendency bets, a trending volatility-selling strategy aimed at generating a yield on top of spot market holdings. As a result, market makers have been stuffed with long call positions or positive gamma. Options gamma is the price of change in the options price in response to changes in the underlying asset’s price. And once gamma is positive, options become pricier when the underlying asset’s price rises or falls.
Holding large positive gamma forces market makers to trade against the direction in which the spot prices move to keep their books delta neutral. And, if Bitcoin (BTC) and ether fall, the options market makers, stuffed with positive gamma, must buy digital currencies in the spot market. Similarly, they need take bearish bets in spot/futures markets if the market rallies. This hedging activity has been keeping prices locked in the narrow range.
“These substantial call overwriting programs have left dealers stuffed long [positive] gamma. So it becomes a negative feedback loop as the gamma hedging keeps spot ranges contained, weighing further on volatility, then dealers likewise try to lighten on long gamma positions,” David Brickell, director of institutional sales at cryptocurrency liquidity network Paradigm, said.
“In the absence of a catalyst/narrative to begin taking a directional danger, that systematic, mechanical volatility selling will keep weighing,” Brickell added.
The episode shows the growing influence of the options market on spot prices, a common feature in equities and foreign exchange markets. Cryptocurrency investors persistently purchased call options during the bull market of 2021, leaving market makers with short gamma positions. That required market makers to trade in the direction of Bitcoin (BTC) and ether to balance their books, which resulted in exaggerated price moves.
Per Griffin Ardnern, a volatility trader from a cryptocurrency investment management company, the positive gamma in ether has hit a record high and the sticky effect of market makers’ hedging activity could weaken following the monthly options expiry. Deribit, the world’s largest cryptocurrency options exchange that controls nearly 90 percent of the market, will settle May expiry options on Friday at 08:00 UTC.
” When it comes to positive gamma, the delta hedging behavior of market makers is to sell high and buy low, which compresses the price movement range to near the strike price,” Ardern informed CoinDesk.
” Following the settlement, the sticky effect of hedging on the price will significantly weaken, and there may be stronger resistance, particularly in Ethereum (ETH). It is necessary to be careful about the danger of Ethereum (ETH) price going downwards.”
Since May 12, Bitcoin (BTC) has traded the narrow range of $25,800 to $27,600, while ether has consolidated betwixt $1,750 and $1,850. At the time of publication, Bitcoin (BTC) and ether changed hands at $26,350 and $1,800, respectively, per CoinDesk data.