Thread by @Volhalla_

Is selling crypto options for yield an attractive strategy?

With the rapid growth of DeFi Option Vaults (DOVs), you may be wondering whether this is an attractive risk-reward strategy to generate income. A thread (1/9)

In TradFi, selling volatility or options is a common strategy used by funds to generate yield. When investors use a recurring options selling strategy (similar to what DOVs offer in crypto), they are trying to harvest what is known as the volatility risk premium (VRP).

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VRP is the extra compensation options sellers earn for providing protection to option buyers. It is similar to insurance premiums. If car insurance companies only charge for the expected loss of you getting into an accident, they wouldn’t make any money!

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Insurance companies and options sellers need to charge more – this extra charge is the VRP. Insurance and option buyers are typically happy to pay a premium as it reflects behavioral biases for humans to be risk averse or over-estimate the probability of catastrophes.

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Yale does an annual study where they ask investors to estimate the likelihood of a “catastrophic market crash” in the next 6 months. Since the study began in 1989, 2/3rds of participants estimated the likelihood of a crash to be 10%. In reality the likelihood was only 1%.

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Investors can take advantage of this bias by consistently selling options. AQR Capital analyzed the returns of selling 5% out-of-the-money 1month puts on the S&P over a 20yr period and found that the strategy had an attractive Sharpe ratio and low correlation to the S&P.

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Bill Gross (founder of PIMCO) said option selling was one way he generates “structural alpha”. Bill would consistently sell options with notional size of 10% of his clients’ portfolio value. He liked to sell strangles (a strategy where you sell both a call and a put).

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The volatile nature of crypto may mean there is a large VRP in crypto options that can be harvested. Crypto investors now can deploy the same strategies and principles that TradFi investors have used for years to generate consistent income in their portfolios.

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DOVs make this easy but not all vol selling strategies are created equal. Stay tuned to hear more about how Volhalla will offer the next generation of volatility selling strategies via strangles, spreads, and exotics.

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