Sometimes, investors come across trading opportunities that offer outsized returns, but they may not fully understand the risks they are taking on. These risks can include operational risks, counterparty credit risks, or hidden optionality within a financial note.
Reference [1] examines the role of liquidity risks in the returns of bitcoin options. In the bitcoin options market, market makers face significant challenges in hedging inventory risk due to price jump risks and lower liquidity. As a result, they charge a higher risk premium. The authors pointed out,
The Bitcoin options market remains notably illiquid, with significant implications for pricing and expected returns. Our analysis reveals that investors, on average, tend to sell options, though this net sell imbalance has lessened with the growing participation of small retail investors. This illiquid market structure leads to a notable illiquidity premium, where higher illiquidity is associated with increased subsequent delta-hedged returns. Using both panel OLS and IPCA factor models, we find a robust and significantly positive relationship between illiquidity and expected option returns, consistent across various illiquidity proxies and model specifications.
The economic rationale behind these findings suggests that the illiquidity premium compensates market makers for the risks and costs associated with market making. Regression analyses indicate that option relative spreads are influenced by delta-hedging and rebalancing costs, inventory costs, and asymmetric information. Importantly, relative spreads remain a significant determinant of expected returns, particularly for options with negative order imbalances, and delta-hedging costs impact returns across the board, implying the presence of additional contributing factors.
In short, Bitcoin options market makers and active traders earn excess returns, partly driven by the illiquidity premium.
This research is noteworthy as it provides insights into the returns of options strategies in the Bitcoin options market. With Bitcoin ETF options now beginning to trade, liquidity is expected to improve, potentially reducing or even eliminating the illiquidity premium.
Let us know what you think in the comments below or in the discussion forum.
References
[1] C Atanasova, T Miao, I Segarra, TT Sha, F Willeboordse, Illiquidity Premium and Crypto Option Returns, Working paper, 2024
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