Crypto Senti-Meter: A Derivatives Sentiment Index

Motivation

Derivatives markets aggregate and process a wealth of information in order to accurately price products. As a result, they encode information about market sentiment in their pricing data. For example, a volatility smile that is skewed towards puts indicates a high demand for OTM puts relative to OTM calls, and hence bearish sentiment. Our sentiment index uses several key derivatives metrics that hold significant information about market sentiment, and aggregates them into an easily interpretable measure of sentiment in cryptocurrency derivatives markets.

We begin by taking daily snapshots of perpetual swap funding rates, the 25-delta put-call skew, and futures-implied yields. Our reason for choosing these three features is as follows.

Futures-Implied Yields

Yields are calculated by first computing the constant maturity futures price at a standard tenor, implied by interpolating between the market-traded prices of futures with listed expiries. That price is divided by the current spot price to produce an implied yield, which is subsequently annualised by multiplying by the number of periods in a year.

Positive yields indicate that futures prices are above spot prices, and that traders are willing to pay a premium above the spot price in order to gain long exposure to the underlying. This generally corresponds with bullish sentiment in futures markets. The opposite is true for negative yields – where the futures price trades below the spot, indicating that markets are willing to accept a lower price when shorting compared to the spot price.

Perpetual Swap Funding Rate

When the perpetual swap price trades above the price of the underlying asset that it is designed to track, the funding rate is paid by long positions to short positions, incentivising them to close their long positions and open shorts, applying a downward pressure to the perpetual swap price. The opposite is true when the perpetual swap trades cheaper than the underlying – short positions must pay long positions, or close out their position by buying back the contract.

A consistently positive funding rate indicates that traders are willing to pay a fee for the leveraged long exposure that the perpetual swap contract offers. This tells us that the sentiment of those with long positions is positive/bullish. The opposite is true for a consistently negative funding rate.

Volatility Smile Skew

The skew of the volatility smile measures the difference in implied volatility between OTM puts and calls struck at the same distance from the at-the-money level. By taking daily snapshots of this data at some specified delta, we can plot a time series of the skew, as shown above.

When the skew is positive, it indicates that OTM calls trade at an implied volatility premium when compared with similarly OTM puts. This indicates a higher demand relative to supply for calls compared to puts, and can therefore be interpreted as an indication that market participants are bullish on the underlying asset.

Conversely, bearish market sentiment leads to a higher demand for downside protection from OTM calls, resulting in a higher implied volatility in OTM puts than calls and a volatility smile that is negatively skewed.

Creating the Index

Each of the derivatives metrics introduced in the previous section holds a strong correlation to directional market sentiment. Our key observation is that the level of bullish or bearish sentiment expressed by each metric is highly correlated with each other. We wish to use this fact in order to aggregate the information conveyed by these metrics into a single index that can be used to measure the aggregate sentiment of all derivatives markets.

Weighted Average of Derivatives Metrics

The construction of our index begins by leveraging a Principal Component Analysis to recover a weighted average of each measure of sentiment in derivatives markets that explains over 70% of the variance in the full dataset, collected over the previous 4 years. The resulting time series projection therefore represents the main driver of the directional derivatives metrics we have chosen.

The result is a weighted average of the three input features: a time series that moves strongly up and down when each of the input features move in the same direction, but does not move as sharply when one derivatives metric is at odds with the other two.

Finally, we rescale our index to lie between 0 and 100, with an index value of 0 indicating that derivatives markets are expressing the most bearish sentiment that we have recorded, and a value of 100 representing the most bullish derivatives pricing on record. A score of 50 results from a small funding rate, flat futures curve, and neutrally priced volatility smile.

The weighted average time series holds a strong positive correlation with the futures yields, perpetual swap funding rate, and volatility smile skew that drive it. We can interpret a drop in the correlation between the weighted The weighted average time series holds a strong positive correlation with the futures yields, perpetual swap funding rate, and volatility smile skew that drive it. We can interpret a drop in the correlation between the weighted average and an input feature as that input feature expressing an opposing sentiment to that expressed by the remaining two.

Interpreting the Sentiment Index

The sentiment index shown below tracks BTC spot price closely – sentiment crashes following a spot price selloff, or rises in response to a spot price rally. To illustrate the use of the index, we highlight three historical periods:

1. Bearishness during a crash

2. Falling sentiment as spot slips lower

3. Rising sentiment as BTC begins a rally to all-time-highs

Crashing Sentiment

During the rush from risky assets following the announcement of pandemic lockdowns in March 2020, BTC price fell 64% in the space of just one month. At the same time, the sentiment index crashed from around 95 to near 0, reflecting a dramatic turnaround in investor sentiment.

The futures yield fell sharply negative as traders sold futures short, accepting a lower price than spot. The mark price perpetual swap contract fell faster than the spot price index as traders rushed to gain short exposure, causing a high funding rate to be paid from short positions to longs. Traders rushed to hedge against further downside price action by buying OTM puts, resulting in a strong skew towards puts in the implied volatility smile.

Falling Sentiment

In late 2021, BTC spot price reached all-time-highs before reversing its bullish trend. As BTC spot price fell during the first half of 2022 after first the Luna collapse and then the Celsius crisis, sentiment also fell to near zero levels. Both the futures yield and funding rates fell to neutral levels, while the skew of the volatility smile was consistently negative as traders looked to hedge against further contagion in the crypto-asset market and further selloffs.

Climb to an All-Time High

Towards the end of 2022, BTC spot price bottomed after the FTX crash saw a sharp 27.8% selloff in spot price. Sentiment recovered in the subsequent months as it became clear that further contagion to other exchanges would be limited, and the futures yield, 25 delta PC skew, and funding rates all recovered from historically low levels.

The recovery in skew in January of the following year actually precipitated the recovery of the psychological $20K spot level that was lost in the crash. However, it would take some time for the successive, step-wise spot rallies in the first half of 2023 to lift sentiment above its neutral value of close to 50.

Relationship to Spot

The case study periods in the section above highlight that the derivatives driven sentiment index is strongly correlated with movements in spot on a daily frequency. Rallies to all-time high spot price levels have corresponded with large leveraged long positions in derivatives markets, and crashes have prompted traders to seek downside exposure through options, futures, and perpetual swap contracts.

However, how are we to interpret movements in the sentiment index that cannot be explained by movements in the spot price? Is there an embedded signal in divergences from the long-term trend, and how long does that signal last?

The index of derivatives sentiment has historically held a strong linear relationship to the level of BTC’s spot price. Here, we display this linear relationship from Jan 1st 2020 until the latest data point on the 23rd May 2024. Historically, divergences from that linear trend can be often attributed to changes in sentiment while spot price remains range-bound at a relatively consistent level – this appears on the chart above as a movement up or down in the y-axis while spot remains relatively stable in the x-axis.

Periods where the sentiment index has recorded a persistent value far away from the level implied by its linear relationship to spot price have often preceded movements in spot price. We see an example of this in the chart above in the bright yellow cluster of data points above the trend line at a spot level around of $40K. Soon after, spot prices rallied towards the all-time highs at top right of the chart in March of 2024.