The Merge Conundrum
The Merge is coming
The current Ethereum is to merge with the Beacon Chain proof-of-stake system. Beacon is used to test the system ahead of a full migration to Ethereum 2.0 and functions as a live model of Ethereum 2.0. Ethereum 2.0 is an upgrade from the original ethereum proof-of-work model to the new proof-of-stake network which is meant to be faster and cheaper to use.
The long-awaited Merge of the Beacon Chain and the current Ethereum is finally expected in September. The most likely date is September 19 suggested by Tim Beiko, the lead organizer of core developers. However, the exact timing is probable but not certain.
Options and futures disagree
Options traders have placed big bets on the coming Merge. Ethereum options open interest has reached a new record, becoming higher than the same figure for Bitcoin and in USD terms almost returns to the December 2021 level despite a much lower price. This record open interest is very skewed in favor of out-of-money calls, so it looks like options traders are strongly bullish on Ethereum.
Ethereum options open interest by strike price
I’d like to emphasize that options traders’ optimism is not limited to the strikes closest to the Merge. There are a lot of calls maturing at the year-end and the next March.
Ethereum options open interest by expiration date
On the other hand, Ethereum futures trade in backwardation, suggesting lower prices ahead (until the year-end). It’s particularly striking that Bitcoin futures are in contango, so Ethereum’s backwardation does not reflect a general crypto sentiment and is coin-specific.
Ethereum and Bitcoin futures curves (based on Deribit data)
Options and futures pricing of the Merge is covered in many research reports, but the dissonance between futures and options is rarely discussed. Glassnode says the Merge is priced in as a “sell the news” event, essentially because the futures curve is in backwardation and the volatility smile is flatter after the Merge (on October 28 compared with September 30). However, even after the Merge calls vastly outnumber puts (see the chart above “Ethereum options open interest by expiration date”), the flatter volatility smile just indicates that bullishness is less extreme after the Merge.
The most logical way to reconcile futures and options pricing is a possible fork just after the Merge. A fork is like a dividend or spin-off in the stock market and implies lower value of the original asset after the cutoff date. That does not mean that a dividend is negative for a stock price, but merely reflects available arbitrage opportunities. If a stock price were not to fall after the cutoff date, market participants could earn a risk-free profit by holding the stock through the cutoff date. Thus, the possible fork fully explains the backwardation of the futures curve. Should the curve be not inverted, market participants could buy spot, sell short futures and get any fork value for free. The potentially risky nature of the fork also hints at why so many investors prefer to bet on the Merge via calls instead of spot (being scared of the fork they limit their downside risk).
We can estimate implied value of the fork via the futures curves. Let’s assume that without the fork Ethereum would trade like Bitcoin, so the difference between the futures curves of Ethereum and Bitcoin is explained by the fork. As of August 15, it suggests the fork is worth 1.2-1.3%. That does look much but remember it’s a probability-weighted figure (for example, it may mean 12-13% of value at 10% probability or 25% of value at 5% probability). Extreme investors’ preference for calls instead of spot suggests the fork has a low or unknown probability of high damage to the original asset price.
For comparison, the very old fork called Ethereum Classic is worth about 2% of Ethereum. Interestingly, Ethereum Classic has almost doubled in price compared with Ethereum after the Merge date news in mid-July.
Ethereum Classic price in Ethereum (ETC/ETH)
I summarize my interpretation of current market pricing and implied view:
1. Investors are genuinely positive on Ethereum prospects but are afraid of risks and so prefer calls instead of spot.
2. Both positive view and risk-aversion are quite extreme.
3. Futures imply a small probability-weighted value of the fork which is likely small because of low probability.
For me, it looks like the Merge is riskier than most people realize, but it’s still a major positive for Ethereum. How to get a reward and minimize risks? An obvious way is to buy calls, but they are very crowded and probably overvalued. Moreover, huge open interest in calls, including legacy positions, may limit an upside if these calls become close to at-the-money (on the other hand, a gamma squeeze of dealers is also conceivable).
I believe a simple holding of spot Ethereum provides a good risk-reward if an investor carefully calibrates the exposure in order to account for a small probability of a sizable loss. Selling covered calls for a part of Ethereum holdings may also make sense. For example, $2400-2500 calls maturing on September 30 are priced at about 5% of notional value. For advanced investors, I think the best hedging is to sell short futures maturing on September 30 vs a part of Ethereum holdings. The current futures basis is small and so has a limited downside, but may increase a lot if a high-value fork arises.
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