Monthly market wrap-up: Leverage bonanza

11 Oct 2022

Monthly market wrap-up: Leverage bonanza – Be careful

Leverage is ballooning, while volatility is flattening. All in all, this is a situation that could generate explosive volatility and benefit sophisticated options traders. My long-term view remains unchanged, now is a good time to build exposure.

Short term

Leverage is going full-on parabolic in the crypto derivatives market, as BTC remains in a very directionless state. Meanwhile, funding rates prevail in neutral to below-neutral terrain while futures trade in backwardation. If I were instructed to write a cookbook recipe for a short squeeze, I would add all current ingredients, but I’d love to sprinkle it with more potent signals from the short-term funding rates. As of now, the activity in perps in the last few weeks, unfortunately, indicates a concerningly balanced view between longs and shorts. Thus, while I view the current open interest as well blown above any levels that may be assessed as sustainable, opaqueness from market signals restricts me from having any directional view on the winddown of said leverage. Short term, I would avoid adding risk through leverage in the market, as the current setup is ripe to reap havoc in either direction. However, declining IVs in options and an overwhelmingly flat market represent an opportunity for straddle strategies to position for potential bursts in volatility. If you are unfamiliar with straddles, you should refrain from trading options. Still, you’d consider a short-term position in FTX’s BVOL perp this week as various macro events may introduce new clips of volatility to the market as we anxiously await Thursday’s CPI release. Heck, even the Wednesday release of FOMC minutes or PPI may be sufficient to make the old orange coin move.

Medium term

The strong growth trend in open interest in crypto derivatives is burdensome and will end in violence. Directionally, the effects are currently unclear. While a swift and fast normalization of open interest would be welcome, I would not be surprised if the aforementioned short-term play develops into a medium-term play. We will not see a significant consolidation range breakout without experiencing a significant flush in leverage, and the current leverage levels suggest that a breakout will be very volatile. Few potent catalysts await in the medium term in crypto. However, I expect MicroStrategy’s first BTC purchases to begin in early to mid-November if the pattern from the H2 2021 security offering is anything to go by. If the usual MicroStrategy riddance repeats, expect small rallies and brief hardcore sell-offs as MicroStrategy bids and then announces its purchases for the remainder of Q4 2022. Outside of Saylor’s greedy hand deep into the bitcoin jar, I expect U.S. macro data and U.S. interest rate hikes and tightening policies to be the key directional force throughout Q4, 2022, but I also expect the tightening cycle to calm in force as we near the year-end. This will, in turn, reflect well on bitcoin and other risk assets. We’re already witnessing brief signs of structural issues related to reduced liquidity in various regions, most notably evident in the U.K. with BoE’s recent market intervention in gilts. I’d not be surprised to see more accommodative central banks to follow as new liquidity-pressured skeletons appear from the closet.

Long-term

BTC is on track with previous bear market trajectories, as we’ve seen a 70% drawdown from its November ATH. While previous bears have pressured us lower from peak to through, and this bear might be pushed lower as well, I am fairly confident in more aggressive incremental purchases in the current state of the market. Once the FED has reached an appropriate restrictive interest rate level and inflation shows clear signs of slowing, crypto may again find room to see a substantial recovery. The next year will likely bring idiosyncratic crypto-related regulatory clarity in the U.S., and in a more stable interest rate and inflation regime, this may funnel a new cycle of growth. The tendency of financial institutions currently dabbling into the space with Blackrock, Citadel, and Nasdaq recently announcing crypto products suggests that larger participants are positioning for a new round of crypto market strength, and I am certain that the show will go on, and new highs will be met in a not too far distant future.