As we are getting closer to the CVI trading platform launch, we’ll be releasing a series of articles and guides over the next few weeks, detailing the CVI index and trading platform. In the following article, we’ll give some background on volatility and volatility trading, VIX and CVI, historical scenarios, and more.
What is Volatility?
Volatility refers to the degree of change in variation of prices for a given asset over a specified period of time. High market volatility means prices change fast in a (relatively) short period of time. Non-volatile markets, on the other hand, see the prices change either very slowly or almost not at all.
What is volatility trading?
Volatility trading refers to trading the volatility of a financial instrument rather than trading its price. This allows to increase the asset’s profit or bottom line without having to predict the direction of the market (or the market’s tendency) .. Volatility traders do not concern themselves with the direction of price moves, but rather only trade the volatility itself.
Financial markets volatility is what creates the profit potential, which is why investors and traders live by it. The higher the volatility, the higher the risks, but also the higher the returns potential.
A popular tool to measure and detect market volatility and investor risk is the Volatility Index (VIX) of the Chicago Board Options Exchange (CBOE). The Volatility Index is also often called the “fear index”, as higher readings signal rising fear among market participants. VIX gains are typically a function of global instability, which is also reflected by alternative markets.
The VIX has become one of the most quoted indexes and a cornerstone in many of the trading strategies made by professionals. Investors can use VIX to measure the level of risk, fear, or stress in the market when making investment decisions. Traders can also trade the VIX using a variety of options and exchange-traded products, or use VIX values to price derivatives and by doing so can effectively hedge against the overall market.
The VIX index has paved the way for using volatility as a tradable asset via derivative products. CBOE launched the first VIX-based exchange-traded futures contract in March 2004, which was followed by the launch of VIX options in February 2006. Today, there are many VIX-linked instruments available for trading, including leveraged and short ETN/ETFs as well as futures/options on these instruments. Such VIX-linked instruments allow pure volatility exposure and have created an entirely new asset class. Active traders, large institutional investors and hedge fund managers use VIX-linked securities for portfolio diversification, as historical data demonstrates a strong negative correlation of volatility to the stock market returns — that is, when stock returns go down, volatility rises and vice versa.
Since the invention of Bitcoin, cryptocurrencies have evolved into a new class of financial assets. The emergence of the derivative market has signaled the need for solid pricing strategies as well as reliable risk measures. There is a growing need for a new decentralized volatility index that provides a proper estimation of the risk measurement of the cryptocurrency components, and a delivery of market status information to potential investors.
As such, we believe that the crypto market should have its own decentralized VIX, its own “market fear index”.
Meet CVI — Market Fear Index for the Crypto Space
CVI is created by computing a decentralized volatility index from cryptocurrency option prices together with analyzing the market’s expectation of future volatility.
We have created CVI so that traders can hedge themselves against volatility or lack thereof.
CVI is a full-scale decentralized ecosystem that brings the sophisticated and very popular “market fear index” to the crypto market and is created by computing a decentralized volatility index from cryptocurrency option prices together with analyzing the market’s expectation of future volatility.
CVI is an innovative, decentralized, stable, transparent, informative and replicable benchmark for cryptocurrency volatility information.
Our CVI index calculation is based on a classic approach, the Black-Scholes option pricing model, and is adapted to the current crypto-market conditions. In order to ensure decentralization and transparency, we use Chainlink architecture with multiple oracles to retrieve the required data and calculate the formulated CVI using external adapters. The calculated results from each Oracle are aggregated, verified, and passed to the blockchain node so that the data can be accessed and used both by the requesting smart contract and as a service for other use case implementations.
The combined CVI index is a weighted sum of CVI indices calculated for several cryptocurrencies (for example BTC and ETH), where weights are based on the currency market cap.
Why you want to be a Volatility trader
Trading volatility is a great way to find profitable trading opportunities in the market without committing to the direction of the market. If Volatility increases, you make a profit regardless of the price change.
Higher volatility often occurs following important market reports, and especially upon discrepancies (or incompatibility) between the published number and the market expectations.
Every single asset in which price changes, actually manifests price volatility. So, traders that trade volatility look at how much change, in any direction, will happen. They don’t pay attention to the price, they don’t want to predict the price itself. Such traders just think about how much the price of some asset will move in the future.
Hedge against impermanent loss: Liquidity providers for platforms such as Uniswap are exposed to impermanent loss when one of the provided assets raises/drops faster than the other asset. Taking a position on CVI can allow liquidity providers to hedge against volatility in both directions.
Historical scenarios — BTC trends as reflected in the CVI index
The below chart represents the Bitcoin price chart for 2020 with two visible market events:
- COVID-19 crisis (spring 2020)
- Defi-tokens price crash at the beginning of September 2020
Now let’s examine the CVI chart representing both of these events:
When reading the CVI chart, remember that “Market goes down, CVI goes up”.
Obviously, the above chart shows that there is a strong inverse correlation between CVI and BTC prices.
The following is a 14-day chart of the CVI index (ranged between 10–200), as of October 4th, 2020. This demonstrates the correlation the index has with macroeconomic events that affected the markets, such as the drop in global stock exchanges from September 21st and the events surrounding the Bitmex lawsuits and Trump Coronavirus news on October 1st.
In the next articles, we will review and explain how to trade on the CVI platform, and what to do when the market goes up or down. Stay tuned!