- There are three styles of options execution and five key variables that traders must take into account before entering a position in the options market.
- Opyn and ACO Finance are DeFi options protocols that trade in-line with Deribit’s prices and function like regular options.
- Hegic offers an innovative approach to option selling, and will launch a liquidity mining program in September 2020.
- Choosing between trading on a centralized platform or a non-custodial protocol should be made after considering various factors such as size and strategy.
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Options are one of the most complex and misunderstood financial instruments. Understanding how they work can expand a trader’s, crypto or otherwise, profit-generating tool kit in specific market environments.
Options Aren’t All Fun and Games
Centralized venues like Deribit are the primary venue to trade crypto options. Of late, non-custodial options trading platforms on Ethereum have also been gaining ground. While these options platforms are not as liquid as Deribit and OKEx, they are interoperable with Ethereum’s DeFi stack.
Most permissionless options trading protocols are designed to mimic the traditional options.
But before diving into these instruments, it’s important to highlight that options are one of the most complex financial tools that retail traders have access to. Due to this complexity, inexperienced traders are advised to exercise extreme caution when beginning.
Once grasped, however, the following concepts will enable traders to use the most popular derivative in the world to enhance profits and fortify risk management.
Mastering the Basics
There are three types of option settlements: American, European, and Bermuda. Option pricing is dependent on the style of execution the option follows.
American options allow the buyer to exercise their contracts at any given time before expiration. European options can only be used on the day of expiry. Bermuda options have two dates – expiry and one day in between – on which the option can be exercised.
Since American options give buyers more flexibility, they tend to be priced higher than others.
In general, traders can buy options and expose themselves to capital appreciation, or sell options and earn a premium. Neither of these actions is without risk. One can buy and sell “put options,” as well as buy and sell “call options.”
Users that trade options must also be aware of an option’s “strike price.”
The strike price is the price/level at which the option is exercised. If you hold a BTC call with a strike price of $10,00, it gives you the right to buy BTC at $10k even if the price is at $25,000 upon expiration.
Put buying is paying a premium to receive the option, but not the obligation, to sell an asset at the strike price.
Put selling entails receiving a premium to take the other side of the put buyer. If the price of the asset is lower than the strike price of the put option, the put seller must buy the underlying asset at the strike price from the put buyer.
If you buy a call, you’re purchasing the right to buy an asset at the designated strike price. The premium call buyers pay goes to the person taking the other side of the trade, a call seller.
If ETH is trading at $250 and Alice buys a $300 call that expires on September 25 for a $5 premium, she needs the price of ETH to go above $305 (strike plus premium) by that date to make money.
Bob, who took the other side of Alice’s option contract, will have to sell Alice ETH at $300 even if the price of ETH touches $700 on the date of expiration. However, if ETH is below $300 on the date of expiration, Bob walks away with the premium as compensation for bearing the obligation to sell.
It should be clear that options trading is not black and white. Several factors contribute to pricing, and all must be considered in order before entering a trade.
Trading Options with DeFi
As of today, three DeFi options protocols are live on the Ethereum mainnet.
The first is Opyn, a generalized options protocol. Opyn is built on the convexity protocol. Its primary purpose is to use options as a form of hedging insurance, so Opyn specializes in put options. Opyn also recently launched protective call options for ETH.
Opyn’s protocol allows for both American and European options. But Deribit’s options are all European style, and Opyn’s options tend to achieve price parity with Deribit. Traders can thus utilize Deribit’s options data for trade decisions on Opyn too.
There are money-making opportunities on both sides of the option. Traders can hedge their ETH, BAL, or COMP exposure, and insure their Compound deposits using Opyn.
Liquidity providers (LPs) act as option sellers and earn the premium paid by buyers.
Trading options on Opyn are very similar to traditional options. Options buyers choose their strike and expiry price, post collateral, and pay a premium to purchase an option. Option sellers also post collateral to ensure they meet their obligations and receive the premium paid by buyers for taking this risk.
Providing liquidity (selling) on ETH puts is like being long ETH. In the scenario where the price of ETH tanks, LPs have to buy ETH at a lower price to cover their loss. But if the price of ETH rises, LPs walk away with their premium.
Opyn recently suffered a hack where LPs lost the collateral they deposited in the pool. While the team responded with resilience to the incident, one must always be cautious when interacting with nascent smart contracts.
Another options trading protocol, Hegic, aims to make options trading simpler by abstracting complexities and make it more accessible.
Hegic’s options aren’t structured exactly like traditional options but have several similarities. All contracts on the protocol are American style, meaning they can be exercised at any time.
Upon launch, Hegic was immediately put under pressure as a bug in the code froze 152 ETH worth of LP funds forever.
Shortly after, Hegic was hit by an exploit that allowed option sellers to collect their premium and exit the pool, thereby evading their obligations upon expiry of the options. Once again, Hegic was forced offline and redeployed its smart contract.
But Hegic has bounced back time after time with significant improvements to the protocol. The protocol’s anonymous developer, Molly Wintermute, uses the yEarn Finance approach of testing live on mainnet.
Like Opyn, one can buy or sell options. But Hegic uses a common liquidity pool for both calls and puts.
This is the biggest difference between Hegic and other platforms, as option sellers need not have specific exposure to specific strike prices and expiry dates. Hegic’s approach helps consolidate risks and returns, putting all liquidity providers on equal standing.
Hegic provides LPs with annualized yields of 20% on the DAI pool and 25% on the ETH pool at the time of writing. The DAI pool’s yield opportunities come from selling puts, while the ETH pool caters to selling calls.
Since Hegic uses Americans style options, the premium is slightly higher than Opyn and Deribit. This is good news for LPs (higher returns) and option buyers (more flexibility).
In September, Hegic will launch its native governance token with a liquidity mining program. Users will be given an added incentive in HEGIC to provide liquidity and buy options.
40% of the total distribution will be given to users of the protocol, while an additional 25% will be sold using a bonding curve contract. Using a bonding curve to sell HEGIC ensures each time the token is bought, the price of the token rises a little bit.
The bidding begins at $0.0027 per HEGIC.
Built on Auctus, ACO Finance is another non-custodial options trading protocol built on Ethereum.
ACO uses European style options and, like Opyn, has close price parity with Deribit. However, ACO has call and put options for all the assets it supports, making it a more complete version of Opyn though a less liquid alternative.
Like traditional options, ACO uses a one-for-one counterparty mechanism. This means a trader must choose which strike price, expiry, and type of option (call or put) to sell, rather than providing liquidity to a common pool.
While this increases the risk for options sellers, it lets sophisticated option sellers customize their strategies to gain specific exposure to certain strike prices and expiry dates.
Non-Custodial Options or Centralized?
With soaring gas prices on Ethereum, there’s a big difference between the costs of trading options on centralized platforms like Deribit and non-custodial alternatives.
The benefit with Opyn, Hegic, and ACO Finance is that capital is composable within DeFi and can easily move from one protocol to another. Costs, however, will be much higher. This requires traders to use larger amounts of capital to justify $20 gas fees. But traders cannot use massive size either, as liquidity is not deep on DeFi options.
Deribit and OKEx have superior liquidity and lower execution costs. But they also have minimum order sizes that restrict smaller traders.
Choosing the best place to trade options, if at all, is centered around costs, liquidity, and one’s trading strategy.
Disclosure: One or more members of the Crypto Briefing Management team are investors in Hegic.
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