Tail Risk in Bitcoin: Why Traders are Nervous About a Sudden Price Surge or Plunge

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• Bitcoin traders display apprehension over potential “tail risk,” suggesting significant price deviations.
• An elevated butterfly index mirrors this sentiment, emphasizing traders’ heightened sensitivity to market uncertainties.

Decoding the “Tail Risk” in Crypto

In the crypto sphere, “tail risk” is a term that’s been gaining traction. Simply put, it describes the probability of an asset experiencing a movement of three standard deviations from its current price due to a rare, unforeseen event. This concept captures the essence of unpredictable market shifts which can drastically influence an asset’s price.

Currently, Bitcoin, even after stabilizing around $26,000, following a 10% dip during the week ending August 20, hasn’t escaped this fear. Data from Amberdata indicates a considerable drop in Bitcoin’s annualized seven-day historical volatility — from a staggering 60% early last week to a modest 26%.

Griffin Ardern, a known volatility trader from Blofin, commented on the prevailing market sentiment.

“With Bitcoin’s butterfly index touching its yearly peaks, it’s evident that both investors and market makers are factoring in the tail risk.”

The Butterfly Index: A Fear Barometer

This butterfly index acts as a thermometer gauging the market’s temperature. It assesses the demand for out-of-the-money (OTM) call and put options related to Bitcoin. For the uninitiated, a call option represents the right, but not the obligation, to purchase an asset at a pre-set price at a designated future date. Conversely, a put option provides the right to sell. Generally, a rising demand for these OTM options indicates traders anticipate significant price movements.

In this context, Greg Magadini, the director of derivatives at Amberdata, shared his observations.

“While the current volatility metrics show trust in Bitcoin’s price stabilization, traders are willingly paying a premium for potential tail risks,”

he mentioned in a weekly brief.

The calculation of this index involves a comparison between Deribit’s Bitcoin volatility index (DVOL) and the at-the-money (ATM) volatility. DVOL encompasses pricing for all Bitcoin options, while the ATM centers around the pricing of at-the-money options.

Tying this to broader economic developments, the Federal Reserve’s recent inclination towards prolonged tightening measures has escalated bond yields to their highest since 2007. Typically, such a rise negatively impacts risk assets, including cryptocurrencies. Federal Reserve Chairman, Jerome Powell, emphasized the central bank’s commitment to stabilize inflation at 2%, hinting at longer-than-anticipated stringent monetary policies.

Ardern further predicts a sustained tail risk, especially with the impending release of the U.S. nonfarm payrolls report. Preliminary insights hint at the U.S. economy bolstering its job count by approximately 200,000 last month, maintaining the unemployment rate at 3.6%.