Bitcoin Volatility Trading (BTCUSD/VIX)

[xiaomei]

What are people's thoughts on trading a volatility contract on the price of BTCUSD?  There are many details to spec out so I want to gauge the community's interest and collect opinions.  More specifically, would you be interested and what would your concerns be?
Thanks.

[Stephen Gornick]

How do volatility contracts work?

[xiaomei]

How do volatility contracts work?

Volatility (aka vol) is the sum of price deviations from the average; a measure of choppiness. Vol contracts allow traders to place bets on the volatility of BTCUSD.  If you follow and trade BTCUSD in Mt Gox and Bitcoinica you have already placed bets on the direction of the price.  Vol contracts allow you to place bets on the choppiness of BTCUSD.

For example, BTCUSD is trading at 5.00 and trader "Bull" expects a vol of 10, meaning he expects the price of BTCUSD to rise or fall by 10% to either 5.50 or 4.50.  Meanwhile, trader "Bear" expects a vol of 5, meaning she expects the price to vary 5%.  Since the traders disagree in their vol expectations they can enter into a vol contract.  Depending on the odds that the vol will be closer to 10 or 5, trader Bull will need to pay or receive enough bitcoins from Bear such that both parties agree to enter into the contract.  Once the traders are bound by the contract, they will exchange bitcoins daily depending on whether the vol on that day is closer to 5 or 10 and in proportion to how far their vol expectation is from the actual vol.  A vol of 1 would mean Bear receives bitcoins from Bull and a vol of 15 would mean Bull receives bitcoins from Bear. The contract would have a duration of a month and you could close out your contract earlier by selling in a secondary market with an electronic order book.

There are many details I left out in this example but I hope it explains how a Bitcoin vol contract would work.  Volatility contracts on US stocks are heavily traded; look up the VXX stock ticker.  If there is enough interest from the community I can prepare a more detailed specification and demo so people can play with.  However since there are many ways to specify the rules of the game I thought it would be better to hear what people have to say.

[Andrew Vorobyov]

I thinks it's too early for Bitcoin to have VIX... let's take care of trading volumes first

[xiaomei]

It may be too early indeed for a Bitcoin VIX contract.  However, you could imagine trading interest in a vol contract to correlate with increased interest in spot.

[Fireball]

Just one question. Who would be a market maker for this contract?

[FreeMoney]

Just one question. Who would be a market maker for this contract?

I might make some market really wide after seeing a bit of data.

[xiaomei]

The contract will need natural flow of buyers and sellers.  A market maker can't take too large of a long or short position for too long.

[FreeMoney]

The contract will need natural flow of buyers and sellers.  A market maker can't take too large of a long or short position for too long.

Yeah, I'd be surprised if there was enough natural market for this now, but getting it ready is not a bad idea imo.

[Fireball]

The contract will need natural flow of buyers and sellers.  A market maker can't take too large of a long or short position for too long.

This is the main problem. Technically, it's easy to add BTCUSD/VIX to my trading platform. But empty orderbook leads to inability to guarantee execution of a contract, or perform a forced position liquidation.