Transcript of interview with Professor Xu Zhe (Part 2): How do miners use options to increase their profits?

The following article is from Deribit's trading course, written by Deribit Sarah

In "Interview with Professor Xu Zhe (Part 1): How Miners Use Cryptocurrency Derivatives to Increase Profits", Professor Xu Zhe talked about miners who are not pure currency-based or have faith in Bitcoin. They need to guard against the risk of shutdown while also wanting to enjoy the profits brought by the surge in Bitcoin. They can adopt the method of "futures hedging".

Miners who are purely based on fiat currency will short BTC equivalent to "expected BTC output + electricity costs, etc.", while miners who are not based on pure fiat currency will only need to short BTC equivalent to "electricity costs."

The combination of electricity cost futures cover is similar to a call option - when the risk of not being able to pay the electricity bill has been covered, we have invested in mining machines (similar to paying a certain option fee), and within a certain period of time in the future, we have the right to obtain some BTC.

So, is there a combination that can further determine the return? Yes, and this is where we need to introduce the powerful tool of "options".

01
Short Call is a better way

A better way for miners is to sell call options (Short Call). Because the combination mentioned above is option-like, and options have a market provided by exchanges, we can calculate the difference between their present value and the current price (Call).

Assuming that three months later, this batch of mining machines can still generate 10 BTC for you after covering the electricity bill. Then the fees paid by this batch of mining machines can get 10 BTC without the risk of currency price decline and electricity bill burden, and then see how much the 10 BTC Call Option is worth when it expires on March 27, so that this part of future income can be cashed in in advance through the options market.

Then the risk is very small. If you sell call options for hedging, it doesn’t matter because you can definitely redeem BTC at maturity. For example, if you are optimistic that Bitcoin will rise to around $8,700 in the future, the electricity bill has been covered, that is, if you can definitely pay the electricity bill, you still have 10 BTC. Then:

One way is to keep all 10 BTC open (hold spot) and earn as much as BTC soars; another way is to make a call if you think BTC will soar in the next two or three months. In the latter case, there are only two results: one is that BTC does rise to 10,000 US dollars, and the other is that it does not rise to 10,000 US dollars.

1. BTC did not rise to $10,000, and received Call Premium

As a seller, you will not be exercised, and you can get the Call Premium for free. Let's take a look at the exchange's quotes. On March 27, the price was above $10,000. You originally only got 10 BTC, but now you can get 10.64 BTC. Why not?

2. BTC rises to more than $10,000, and the average delivery price is Strike Price + Call Premium

As a seller, you will be exercised, so how much will you actually pay for the BTC? We can calculate that the current single exercise price is $574. But because BTC has risen, this is a reverse contract. If it rises to $10,000, you will actually be delivered at $10,660.

02
Selling options has positive expectations

But some people will laugh and say that if BTC price rises to 10660 USD and you settle it, you will lose money. In fact, you will not lose money, but you will earn less. People feel that earning less is as bad as losing money. Let’s not talk about how immature this idea is. In fact, from the perspective of option pricing theory, in the long run, being a seller must be more advantageous.

In general, if you sell options, the premium you get will converge under the law of large numbers, and you will be more comfortable in the long run than if you don't sell. Because Realized Volatility (RV) and Implied Volatility (IV) are RV<IV in the long run. In other words, if BTC rises to $10,000 and you get the equivalent selling price of the Premium synthesis, even if it is not as cost-effective as hedging this time, in the long run, as long as the option pricing is effective, your income must be better than not going for the Short Option.

In short, if you have no risk in electricity costs and can still obtain a certain amount of BTC, then there is not much difference from a call option. You can use the relatively high price of the call option to lock in the present value. This is still an arbitrage idea. We calculated the arbitrage behavior of mining machines (considering it as a portfolio asset similar to call options) and call options (especially an option market with implied volatility higher than lookback volatility and a relatively high absolute value) under the condition of electricity cost futures locking.

?The combination of holding mining machines and electricity fee Futures Cover is similar to a call option

So, will you miss out on the benefits of the historic surge in BTC? For example, if you are optimistic that BTC will rise to $100,000, will you miss out? No. Because the price of Short Call rises with the underlying price, you cannot expect it to rise to $100,000 in one day.

This process is similar to: BTC rose from more than $10,000 to more than $15,000, then rose to $22,000, fell to $18,000, then fell to $16,000, and then went up again. In this process, the value of the fluctuation will be condensed into the option contract.

You can think of options as the solidification of the possible gains from buying low and selling high brought about by the price fluctuation of the underlying asset, and it is a solidification with a certain premium. This is a bit abstract, you can think of it as a quasi-integral form. Suppose there is a person who can do dynamic hedging infinitely, and the profit he generates is equivalent to the price of the option. If you sell options, it is equivalent to having an infinitely small hedging space, and your accumulated gains are actually equivalent to selling options. Of course, it does not mesh so well with the theory, because the theory is limited after all, but in fact, the actual effect is better in terms of effect. In the process of continuous rise and fall, the gains that can be generated by buying high and selling low are equivalent to selling options in the long run.

For example, if the price of the coin keeps rising, the strike price of the put option will also rise. This is different from the first method - directly locking the output of the mining machine during its life cycle with futures. The price of the coin starts to rise from $9,000 to $10,000 and $12,000. After covering the electricity bill for this period each time, the coins generated will continue to rise with the rise in the price of the coin, and the strike price of the sold call option will also continue to rise. In the end, the average selling price you use the option to deliver will definitely be higher than the average selling price (hedging with futures), because the sell option is a positive expectation.

I have a long-term BTC account, which I started with 10,000 USD. The BTC price has been falling, rising, falling, and rising again, so my cumulative average selling price can reach about 12,500 USD to 13,000 USD. I keep short calling, and then calculate its strike price this time. If it is lower than my call strike price (Strike Price), it will be recorded as income Premium; if it is higher than the strike price, then my average selling price this time is Strike Price + Premium.

I calculated the selling price by adding each Premium accumulation and all the delivered Strike Prices, and the average selling price was around $12,500 to $13,000. If the price of the coin suddenly rises to more than $13,000, then the execution price I choose must be between $14,000 and $15,000.

As long as there is volatility and the option pricing is not invalid, my average selling price must be higher than the direct selling price. In that case, it is equivalent to using options to discount the volatility income, and the output of the mining machine can bear the risk of Short Call. In this way, it can take into account the shutdown risk caused by the decline of the currency price and the unlimited income problem of the rise of the currency price, and also get the premium of the high volatility of the Bitcoin options market.

There are a lot of technical details involved here. The most worrying risks have been controlled, because the most feared thing about mining is the shutdown price of the coin. This is very helpless. No matter how big your wealth is, the efficiency of your work becomes negative when the shutdown price of the coin is reached. In fact, the larger your wealth, the more you lose. Big miners have also faced this problem.

03
Risk Control: The number of Short Calls should be strictly limited

The biggest risk of selling call options is that the price of the currency rises very quickly. If the price of the currency rises very quickly, although selling call options is a positive return in the long run, it is very likely that your position will be liquidated before your positive returns converge. The market can be irrational for longer than your position is liquidated, so you have to be on guard. It cannot be said that it is a positive expectation. If I keep doing it, I will definitely get a profit. No, you still have to control the risk, and you have to live until the day when Bernoulli's law of large numbers takes effect.

Don’t be too “wasteful” in mining. When the mining machine can still give you 10BTC or 20BTC output after covering the electricity fee, as long as your Short Call does not exceed this amount, your selling risk will be controlled. You can enjoy the positive expected return of the BTC Option Market High Volatility, and ensure that the output of the mining machine will not miss the surge in Bitcoin. If there is any, you don’t have to worry about the risk of Short Call being liquidated.

Of course, not everyone is like this, and not everyone has unlimited margin. Everyone should be more conservative. For example, if the number of calls I sell does not strictly exceed the output of the mining machine, the risk is controllable. You can short a call with a very high IV, and you don’t have to worry about being liquidated because the mining machine can be delivered, so it’s OK.

So at this level, do we have the best of both worlds? No, that’s not the case. We’ll find out next time.