DVOL - Deribit Implied Volatility Index

What is the DVOL Index?

The DVOL index, provided by Deribit, measures the implied volatility of Bitcoin. Implied volatility is the market's forecast of a likely movement in Bitcoin's price and is derived from the prices of options. The DVOL index offers a standardized measure of this volatility, making it easier for traders to gauge market sentiment and potential price movements.

Comparison to the VIX Index

The DVOL index is similar in function to the VIX index, which measures the implied volatility of the S&P 500. Both indexes provide a 30-day volatility metric, incorporating all strikes and expiration dates within that period. This standardization simplifies the analysis by offering a single volatility figure, rather than requiring traders to assess multiple options.

How the DVOL Index Works

The DVOL index is calculated using a method that involves several steps:

Isolating Out-of-the-Money Options: The DVOL index focuses on the time value of options by isolating out-of-the-money (OTM) options and excluding in-the-money (ITM) options. This requires knowing the forward price of Bitcoin, which is extracted using put-call parity from the options market.

Targeting 30-Day Constant Maturity: The index targets a 30-day constant maturity by analyzing options closest to 30 days from expiration. It extrapolates between options with slightly more and slightly fewer than 30 days until expiration, adjusting continuously to maintain a consistent 30-day maturity.

Maintaining Constant Vega Exposure: Vega measures the sensitivity of an option's price to changes in volatility. The DVOL index adjusts the weighting of options based on their strike prices to ensure a constant vega exposure. Options with lower strikes (and thus higher sensitivity to volatility changes) are weighted more heavily than those with higher strikes.

Practical Implications for Traders

Volatility indexes like the DVOL and VIX allow traders to engage in volatility trading without the complexities of dynamic hedging or the effects of path dependency and theta decay. Here are some practical considerations:

Standardized Volatility Metric: The DVOL index provides a single, standardized volatility measure, simplifying the process of assessing market conditions. This can be particularly useful for traders looking to hedge or speculate on Bitcoin's volatility.

Volatility Futures Trading: Volatility index futures, such as DVOL futures, enable traders to bet on future volatility levels. However, it's important to note that the futures price and the index price may differ until expiration, where they converge. This difference can result in decay costs for futures buyers or sellers, depending on market conditions.

Carry Costs and Risk/Reward: The DVOL index can highlight favorable risk/reward ratios for futures traders. For example, in low-volatility environments, being long on DVOL futures may seem attractive, but the associated decay costs can erode profits if volatility remains low. Conversely, in high-volatility environments, shorting DVOL futures may incur decay costs if volatility stays elevated.