How it is Possible to Decentralize the VIX
Cryptocurrency trading has reached the mainstream, as several traditional investment platforms are now allowing investors to buy, sell and hold crypto assets. Most recently, the investing platform Public — a competitor to Robinhood — announced support for cryptocurrency, allowing investors to manage crypto assets alongside their stock market portfolios. Moreover, a survey published by the University of Chicago in July this year found that 13% of Americans bought or traded cryptocurrency in the past 12 months.
While it’s notable that crypto is gaining momentum, financial tools that allow traders to hedge or take profit from market volatility are needed more than ever. For example, just as the Cboe Volatility Index (the VIX), known as the market’s fear gauge, serves as an index of 30-day implied volatility for the S&P 500, the crypto market now requires a decentralized tool to help traders hedge against volatility or lack thereof.
This is why COTI launched the Crypto Volatility Index, or CVI, in October 2020. The CVI is the first decentralized version of the VIX, tracking the 30-day implied volatility of Bitcoin and Ethereum. Interestingly enough, COTI partnered with Dan Galai, the creator of the original VIX, to develop the CVI, which leverages crypto option prices, along with analysis of the market’s expectation of future volatility, to compute a decentralized volatility index. A network of Chainlink Oracles provides information used for this purpose.
The VIX works similarly by looking at expectations of future volatility, or implied volatility. For instance, times of greater uncertainty (more expected future volatility) often result in higher VIX values, while less uncertain times correspond with lower values.
Although the CVI differs from the VIX in the sense that it’s decentralized to function within the crypto market, there are certain similarities in terms of correlation.
First and foremost, it’s important to note that both the CVI and VIX function as “market fear indexes”. As such, both of these tools measure the estimated volatility of underlying assets as is implied in the exchange traded option prices.
VIX-SPY rolling 30-days correlation. Source: Cboe, Quotemedia
Regarding the VIX, it’s clear that the volatility of a traded asset is a measure of its stochastic deviations from some sort of trend. For example, the less deviation there is from a trend, the smaller the value of the index will be.
Dow Jones Industrial Average. Source: Wikipedia
Interestingly enough, there are two explanations for this secular trend. The first is that stocks are rising in the long-term due to the creation of capital in the economy, which in turn is increasing productivity and labor. The second is that prices are skyrocketing in the short-term because of government stimulus that is flooding the global financial system with liquidity.
As such, a dependency becomes apparent — the more stable the market is, the smaller the stochastic deviations are from the growing trend, and the smaller the VIX value is. This entails exactly what we see — a negative correlation.
According to Modern Portfolio Theory, this kind of correlation is welcomed, since assets with a strong negative correlation make it easier for investors to build diversified portfolios. If an asset has a negative correlation with the S&P 500, that is even better, because it means that we have an asset with a negative “beta”.
It’s also important to point out that well designed portfolios can efficiently shift out risks from “volatility events.” The following is a list of major volatility events from “The VIX Trader’s Handbook: The history, patterns, and strategies every volatility trader needs to know” by Russell Rhoads:
It’s apparent that these events are not frequent, which isn’t great for analysis of the CVI, as the COVID-19 pandemic falls into this category. However, we can still look at the correlation charts for cryptocurrencies to determine the similarities between the VIX and the CVI.
CVI-ETH rolling 30-days correlation (the CVI-ETH index and the correlation are related to the right axis, and the correlation is in percent units). Source: COTI
While a clear anti-correlation pattern isn’t as apparent as it is in the VIX, volatility events are still evident. For example, there are two clear volatility events on the charts — the first is the global COVID-19 pandemic, which started during March 2020:
CVI-BTC rolling 30-days correlation in March 2020. Source: COTI
In addition, upon careful examination of the charts above, we see that a positive correlation occurs mainly when the underlying asset grows. For instance, there is a clear pattern showing the crossing of an asset (BTC) price line and volatility index line. There is also a negative 30-day rolling correlation value (anti-correlation).
When compared to the VIX charts, we see that the CVI behaves similarly.
VIX-SPY rolling 30-days correlation typical pattern. Source: Cboe, Quotemedia
A similar behavior is also evident when the Bank of China banned Bitcoin in May 2021. This is a crypto-world event, so we can’t compare CVI and VIX behavior entirely, but the CVI anti-correlation patterns are clear:
CVI-BTC rolling 30-days correlation in May 2021. Source: COTI
Of course, we are aware that two cases are not enough for a solid comparison, but we can clearly see that the CVI works as expected for all major volatility events.
In terms of positive correlation periods, it’s notable that the underlying asset is primarily growing. During these time frames, there were 25% more days of Bitcoin growth, and the asset enjoyed more than 18-fold growth. For Ethereum, the periods of the positive correlation have 20% growth days and 32-fold cumulative growth (it was played down by decreasing during the days of negative correlation).
It’s also crucial to understand why the negative correlation of the VIX being based on the secular growth of stocks does not work for cryptocurrency. We suppose this is the case due to the fact that market participants do not believe that the growth of Bitcoin can be sustainable.
For instance, the more BTC grows, the more investors are afraid of a reversal or a crash. When Bitcoin reaches fresh highs, investors become nervous, and therefore both implied volatility of options and the CVI index reveal this. We can see solid examples of such behavior on our charts during August 2020 and at the end of 2020.
Given the observations above, we can now determine that the rolling correlation between the CVI-family index and its underlying asset is an important indicator. When it is negative, the market behaves as a normal market.
But when the correlation is positive, it tells us that the market is unstable. As a result, crypto traders can see huge profits as well as major losses. This is also the case for the VIX in regards to traditional stock options.