The widespread anticipation for the approval of spot bitcoin ETFs concluded with a paradoxical decline in bitcoin's price in a classic case of "sell the news".
The lead-up to the approval of spot bitcoin ETFs saw a surge in bitcoin's price, fueled by speculative optimism in the short-term. Investors banked on the premise that ETFs would democratize bitcoin access, attracting a flood of institutional and retail investment. This optimism was not unfounded; historically, the introduction of ETFs has been a boon for underlying assets, such as gold, offering broader market exposure and enhanced liquidity.
However, the actual approval of these ETFs marked a turning point, with bitcoin's price experiencing a sharp decline. This counterintuitive outcome can be attributed to a "sell the news" event, a phenomenon where investors capitalize on the run-up to major announcements by exiting positions once the news is out.
Bitcoin's behavior around major events such as the launch of CME bitcoin futures in December 2017 and the Coinbase IPO in April 2021 reveals a pattern of initial enthusiasm leading to price spikes, followed by corrections. These cycles suggest a propensity for bitcoin to enter periods of consolidation post-major announcements. Currently, bitcoin's price remains extended from its 200-day moving average, indicating a potential for range-bound trading.
Bitcoin’s Recent Runup
Source: Bloomberg Finance, L.P., as of January 31, 2024.
Bitcoin's high volatility and its large drawdowns can be attributed to several factors. Firstly, its market is relatively nascent, leading to price sensitivity based on news, regulatory changes, and market sentiment. Secondly, bitcoin's value is largely driven by speculative interest rather than intrinsic value, making it susceptible to rapid price swings as investors react to short-term developments. Thirdly, liquidity can vary significantly, with large transactions having the potential to move the market considerably. Additionally, the decentralized nature of cryptocurrency markets means that geopolitical events, regulatory announcements, and technological advancements can have unpredictable impacts on price. Together, these aspects contribute to bitcoin's volatility, making it capable of producing significant gains but also exposing investors to the risk of substantial drawdowns. In fact, bitcoin is in the midst of a 37% drawdown as of today.
Bitcoin has Experienced Periods of Long Drawdowns
Source: Bloomberg Finance, L.P., as of January 31, 2024.
Leveraging Range-Bound Markets with Covered Calls
In the context of a range-bound market with high volatility, a covered call strategy on bitcoin presents an attractive potential opportunity for income generation. This strategy entails holding a long position in a bitcoin futures ETF while selling call options on the same asset. The objective is to earn premium income from the options sold, which could provide returns even if the underlying asset's price remains stagnant.
A covered call strategy is particularly suited to range-bound markets for several reasons. First, it seeks to capitalize on the lack of strong directional movement in bitcoin's price, helping to allow investors to generate income from the premiums of the call options sold. Second, should the price of bitcoin rise to the strike price of the call options, the investor potentially benefits from the appreciation of the underlying asset up to the strike price, in addition to the premiums received.
Implementing covered call strategies on volatile assets like bitcoin can help mitigate drawdown challenges. Due to bitcoin's high volatility, investors could earn high premiums thanks to the greater risk of price fluctuations. For context, bitcoin’s historical volatility is 5 times greater than that of global equities. When an asset experiences significant price fluctuations, the premiums for call options increase, reflecting the heightened risk and potential reward for option buyers. This strategy helps to provide a buffer against the asset's volatility, turning market fluctuations into a potential opportunity for income, making it particularly attractive for assets with high volatility.
Bitcoin’s Volatility Makes it Well Suited for a Covered Call Strategy
Source: Bloomberg Finance, L.P., as of January 31, 2024. Global stocks represent the MSCI ACWI, Global Bonds represent the Bloomberg Global Aggregate Index and Cash represents the Bloomberg 1-3 Month U.S. Treasury Bill Index.
Implications for Investors
For investors navigating the post-ETF approval landscape, the shift towards range-bound trading may necessitate a reevaluation of traditional approaches to bitcoin. The covered call approach offers a method to potentially derive value from bitcoin without relying on significant price appreciation in the near-term. It also has the potential benefit of increasing an investor’s income and improve their risk-adjusted returns.
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