Hedging Bitcoins With Options on the World Wide Web: Expert Blog

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Since the beginning of 2017, Bitcoin price has increased sevenfold, with a few sharp drops and this volatility has given way to the development of Bitcoin options.

Bitcoin options are not for the faint-hearted. They trade like any other basic call or put option, in which an investor pays a premium for the right - but not obligation - to buy or sell an agreed amount of currency on an agreed date. Currently, there are two types of Bitcoin options—a binary option and an exchange-traded option.

Binary Bitcoin Options

A binary option is a simple type of option that is valued according to a true/false statement. For example, if the price of the underlying asset Bitcoin is above a certain level, the call (long) option will pay 100; if it is below, it will pay 0. For a put option, the reverse is true.

Binary options make for simple valuation and are therefore a good way for traders to avoid complicated valuations, which often work in favor of option issuers to the detriment of buyers.

• There are two different ways to use Bitcoins for binary options trading: The first is as a payment method at a standard binary options broker – you deposit your Bitcoins at the site and trade using the various assets. This is similar to playing at a Bitcoin casino – your Bitcoins are the currency and you trade/play in the same way as someone using fiat currencies as a deposit.
• The second method is trading Bitcoin as an asset. Several brokers offer this option as one of their many assets, while others deal solely in Bitcoin trading.

Both types of brokers are often referred to as a Bitcoin binary options brokers (BBOB).  Most BBOBs only offer it as a virtual currency pair versus the USD.

Exchange Traded Bitcoin Options

On July 24, 2017, in a breakthrough ruling, the US Commodities Futures Trade Commission (CFTC) approved a proposal to launch a regulated Bitcoin derivative clearing market, New York-based LedgerX. According to the company, LedgerX allows institutional investors to obtain virtual currency and then hedge its volatility using a US federally regulated venue. “Initially, LedgerX intends to list a Day Ahead Swap and one to six month Bitcoin to US Dollar options contracts,” a company spokesman said. Noting that “the New York-based LedgerX, the first and only digital currency exchange and clearinghouse licensed by the US Federal Government, has begun exchange and clearing operations for centrally cleared Bitcoin contracts. In the first week of trading, 176 swaps and options contracts traded with notional values of more than $1,000,000.” These trades were executed by 20 institutional investors -- including investment banks, asset managers, hedge funds and proprietary-trading shops.

At a Bitcoin derivatives exchange, virtual currency listings and prices are tracked and can be looked up by ticker symbol.  By publishing continuous, live markets for Bitcoin option prices, an exchange enables independent parties to engage in price discovery and execute transactions. Chicago Mercantile Exchange Group (CME) and Chicago Board Options Exchange (CBOE), the world's largest options exchanges will roll out Bitcoin futures by the end of this year or early next year.  The largest futures market in Argentina, the Mercado de Termino de Rosario (Rofex) is considering offering Bitcoin futures as well.  Other platforms that offer virtual currency options trading are Bitcoin Mercantile Exchange, owned by Seychelles-incorporated HDR Global Trading Ltd., Deribit of Amsterdam, Singapore-based Coinut options exchange and Dublin-based Predictious.

Bitcoin Invested Hedge Funds

Options are widely used to manage hedge funds’ portfolio risks or “to hedge or speculate on the price of an underlying asset with a quantified risk,” according to retired hedge fund manager Michael Steinhardt, whose career earnings made him a legend in the industry.

Steinhardt set up his first fund in 1967, “following a strategy created by Alfred Winslow Jones. He married (1) short sales to hedge against stock market risk; (2) leverage to boost stock trading returns; (3) and long positions in stocks, to continuously extract stock market trading profits as their prices moved up and down.”  

Steinhardt, in an interview, explained that he expanded on Jones’ strategy  “by incorporating bonds in addition to stocks, as well as new derivative hedging products that entered the markets in addition to short sales” to his portfolio, throughout his career.  He  began hedging with “long and short exchange-traded stock options to hedge the price of stocks when stock options debuted in 1973, at the  CBOE.” That same year, two professors, Fisher Black and Myron Scholes, conceived the Black Scholes Options Pricing Model, which standardized options pricing at options exchanges. Over a period of 28 years, using  his own “Steinhardt Style Hedged Trading Strategy,” he earned “hedged annual returns of 24.5 percent - triple the S&P 500 average,” Steinhardt said.    

The illustrious careers of hedge fund legends has inspired contemporary Bitcoin traders, to set up Bitcoin-invested hedge funds that surf Bitcoin’s extreme price volatility on the world-wide-web just like:

• Michael Steinhardt (1967-1995, 24.5 percent);
• George Soros who incorporated foreign exchange in addition to stocks and bonds to his hedge fund trading strategy was only deemed the title "the Man Who Broke the Bank of England” when he successfully shorted the British pound out of the  European Exchange Rate Mechanism (ERM) mechanism. He became a billionaire overnight on Black Wednesday, September 16, 1992 (1973-2011, 20 percent);
• Bruce Kovner, the global macro hedge fund manager who incorporated commodities in addition to stocks, bonds and foreign exchange to his hedge fund and combined computerized as well as traditional trading strategies to arbitrage world financial markets, like Mozart’s piano sonatas (1983-2011, 14 percent); and
• Prof. David Shaw, the quant who developed first of its kind computerized hedged-trading strategies for stocks, bonds, foreign exchange, commodities, asset backed securities, convertible securities and reinsurance contracts to exploit inefficiencies in world financial markets with the help of state-of-the-art high-speed computer networks (1988-2012, 14 percent).

Since CFTC’s approval of New York-based LedgerX, 70 additional Bitcoin-based hedge funds announced that they would be launching soon. Among these hedge funds is Silicon Valley-based Pantera Capital, which will launch a SEC, registered $100 mln ICO focused hedge fund. And French bank BNP Paribas, which will add Bitcoin to one of its currency funds.  There are now about 120 virtual currency hedge funds:  (1) those that have portfolios containing exclusively virtual currencies, Bitcoin options and ICOs; and (2) those that have added some virtual currency to a mix of other asset types.  

Source: Autonomous Next

In China, the Fintech Blockchain Group runs an exclusively virtual currency invested hedge fund which trades virtual currencies 24 hours a day, seven days a week using a cutting-edge computerized lightning quick trading strategy to arbitrage tiny price discrepancies on the countless web venues where it changes hands. Zhou Shuoji, Fintech Blockchain Group’s high-speed Bitcoin trader said: “It’s the golden age to be in the Bitcoin market because it’s imperfect.”

In the US, hedge fund manager Timothy Enneking of Crypto Asset Management said "I don't think the world has seen but the pointy end of the spear in terms of what's going to happen in cryptocurrencies"  and launched the first SEC-registered Crypto Asset Fund exclusively invested in virtual currency products.  Hedge fund manager, Mike Novogratz who was the president of Fortress Investment Group (US) that was among early investors in virtual currencies and exchanges admitted that "10 percent of my net worth is invested in Bitcoins and it has been the best investment of my life.” Softbank Group acquired Fortress Investment Group earlier during this year.

According to a spokesman for FinCEN, “A foreign hedge fund may have to register with FinCEN depending on several factors. If the foreign hedge fund is registered with, and functionally regulated or examined by the SEC, CFTC or if it engages in activities that, if conducted in the US would require it to register with the SEC or CFTC, then it would not have to register as an MSB. If it does not satisfy this condition, the answer depends on how it operates, on behalf of whom and where its customer base is located.”  

Bitcoin invested hedge funds can be legally structured in a variety of ways.  For example, a Swedish company, XBT Provider that is listed on the Stockholm Nasdaq exchange is structured as an "exchange-traded note" (ETN) that tracks the price of Bitcoin. An unregistered virtual currency hedge fund managed by John Chalekson is structured as a plain vanilla, limited partnership. This hedge fund, using a “game theoretic equilibrium” trading strategy, to “dominate the hedge fund indices with extraordinary numbers,” delivered an astonishing “2,129 percent investment return to his investors through August 2017 primarily by investing in new virtual currencies, ICOs in long positions, without hedging or using any leverage—266 times the S&P 500 average.” Traditional hedge  funds, on average, returned 3.7 percent through the first half of 2017, according to data provided by HFR, and the S&P 500 gained 8 percent over the same period.  

US mutual fund giant Fidelity Investments, with $6.3 tln under administration, joined with the $10 bln Coinbase Inc, a Silicon Valley virtual currency exchange, "to enable Fidelity clients to track their digital assets alongside more traditional investments, like stocks, bonds and mutual funds." Fidelity did so because, a company official said,  “we can see that the evolution of Bitcoin and Blockchain technology is setting the investment industry up for disruption.”

As virtual currencies seep into the current world regulatory and financial infrastructure while transforming it at the same time, the good news is that there are several virtual currency based financial alternatives that will satisfy both the Bitcoin bulls and the bears.

Disclaimer: this article is reproduced with permission from Tax Management International Journal, 46 TM International Journal 575, 10/13/17. Copyright 2017 by The Bureau of National Affairs, Inc. (800-372-1033) https://www.bna.com.