Decentralizing Options — A New Approach (Part 1 of 4)
This is part 1 of 4 articles in a technical series on Wrytes, a leading on-chain decentralized options protocol with automated premium pricing, shared liquidity pools and fractionalized options.
Wrytes is developed by Birthday Research, the Research & Development (R&D) arm of Cake DeFi, and will be launched in Q3 2022.
Find out more about Wrytes in this article.
Introduction
Options are arguably one of the oldest financial instruments in Traditional Finance. Used correctly, it unlocks new possibilities for traders. The DeFi summer has brought many financial instruments from TradFi land over to DeFi land and naturally, options are one of those. However, options in DeFi remain complex, and have not yet reached the level of usability as compared to other financial instruments.
To get a better understanding of how traditional options work, read this introduction to options guide or read more about the advantages of options.
This first part (of 4 parts) will cover:
- The current landscape of decentralized options
- Another approach to solving the existing inefficiencies (Wrytes)
- A deeper explanation into Automated Premium Pricing
The current landscape of decentralized options
Although there are various protocols existing in the market, two popular decentralized options protocols are Opyn and Hegic.
Opyn approaches decentralized options using DeFi Options Vaults (DOVs), where each vault would have a predefined options trading strategy. This means that liquidity providers would only provide liquidity to the vault without needing to plan a trading strategy. For Opyn, a separate vault is created for each specific strike price and expiry. The options are then minted from the vault and can be sold fungibly in an open or secondary market. The price of the option will effectively be the premium paid to the minter.
One issue that stems from DOVs is poor liquidity in the secondary market. A buyer interested in purchasing an ETH call option with a strike price at $3,500 and an expiry date that is 20 days later, would need to look for an available vault with this option specification. If no such vault exists, then the buyer would need to purchase an alternative option instead, or wait for sufficient liquidity to be deposited into this particular vault (ETH call at $3,500 strike price and an expiry that is 20 days later).
Hegic runs with a liquidity pool marketplace and operates on an American-style option. At the time of writing, Hegic supports only ATM (At The Money) options in Ethereum chain and OTM (Out of the Money) & ATM options on Arbitrum. The liquidity of the option comes from a general pool.
As an example, an ETH call option has a unique pool of its own where buyers will be able to select the expiry date and the strike price of the option (only available within a range) to be purchased. The premium of the option is based on a formula which relies on an Implied Volatility (IV) variable which is manually configurable by the Hegic protocol owner, and seems to be set lower than that in Deribit which means that the options sold on Hegic will be cheaper.
Although this method gives option buyers the flexibility to purchase any options, the premium price is dependent on a manual input of the Hegic team and is not fully decentralized. Furthermore, options purchased are non-fungible which will be tricky when looking to resell in a secondary market.
Another approach to solve existing inefficiencies
Existing protocols have their own strengths and limitations and the proposed approach taken for Wrytes is not intended to replace any of the existing protocols. Instead, it aims to take another approach to decentralized options in the DeFi space to give options traders more opportunities and flexibility in their investment strategies in DeFi.
In developing Wrytes, the aim was to build an on-chain decentralized options protocol with:
- An automated premium pricing that depended on the market’s buying interest
- Shared liquidity pools where options of the same class belong to the same pool
- Fractionalized options that enabled buyers to choose the quantity resell them in the secondary market
Automated Premium Pricing
The Black Scholes model is one of the most common and reliable ways to determine premium price in Traditional Finance. However, due to the complexity of its formula and the limitations of an Ethereum Virtual Machine (EVM) environment, directly applying the Black Scholes model to Wrytes was not as feasible. As such, the pricing model was tweaked to make it EVM friendly.
In designing the pricing algorithm of Wrytes, a few factors were taken into consideration. First, in traditional options, one of the factors influencing the pricing of an option is the options greeks. Therefore, a few of these Greek letters were also taken into consideration for Wrytes. Second, similar to traditional options, both the strike price versus the current price as well as the time to expiry will be taken into consideration. Lastly, the pricing would also need to be based on some form of Implied Volatility (IV), which is complex to replicate within the EVM environment.
Therefore, instead of IV, market demand has been used instead.
Strike price versus Current price
With traditional options, the value of an option changes with its strike price. For example, if the option is ITM, the option will be more valuable and we can expect the premium to be higher. Conversely, for options that are OTM, they will be less valuable and cheaper to be purchased.
For options that are ITM, the underwriter of the option will incur a higher risk, therefore they will need to be incentivized to underwrite riskier options, which would explain the higher fees.
The pricing calculator of Wrytes consists of two formulae to mimic this behavior.
Using the example of the a call option:
From the above formulae, when the option is OTM (which means strike price is greater than the current price), the premium will decay exponentially. This represents the loss in value of the option, which increases as the option becomes more OTM. On the other hand, as the option becomes more ITM, the premium will increase exponentially as the underwriter incurs more risk for underwriting the option.
This has been formulated to emulate the delta as the option value moves in accordance to the strike price and the gamma is depicted by the exponential growth or decay of the price.
Time to Expiry
Another important factor that affects the value of the option is the time to expiry.
With time to expiry, the option value decreases with time and this is where Yintercept will be introduced as it will be used to showcase how the property works.
The division by √tperday is just a constant factor to normalized √t and has no impact on our analysis.
√t will mean that when time in seconds increases, the Yintercept increases in a square root fashion. This will be analogous to theta of the option.
Combining time to expiry with the premium price formula, Yintercept gives the premium price curve a ‘starting’ point, which is when the option is ATM. The higher the time to expiry, the higher the value of the ‘starting’ point. Further, the premium price will grow or decay accordingly with respect to the strike price.
Market demand
Another option pricing factor commonly used is the IV of the underlying asset.
Typically, a higher IV will result in a higher premium price. However, IV is tricky to measure and therefore, percentageFactor is introduced instead. This will enable the price to change with respect to market demand. Recall that we briefly introduced percentageFactor as 𝒗 under Time to Expiry.
percentageFactor decreases the longer the option remains unsold, and increases with each option purchase. Intuitively, the longer the option has not been sold, the demand for the option is low and so the premium price will need to be adjusted to be lower to attract potential buyers. Conversely, when there is an option purchase, this signifies an increased demand in the market and the premium will become more expensive.
The percentageFactor will decay exponentially with each passing block and will increase linearly with the amount of an option purchase.
Rounding up
This first article covers a simple premium pricing strategy to determine the premium of an option according to the supply and demand of the market. The percentageFactor serves as the crux that will determine the base price of the premium when the strike price is the same as the current price, and grows or decays exponentially as the strike price decreases or increases relative to the current price.
The next part (2 of 4) will discuss how options can be resold fungibly in an open market. Be sure to keep a lookout for that.
Read more about other projects by Birthday Research or join our community to get updates.
About Birthday Research
Birthday Research is the blockchain R&D arm of Cake DeFi that develops best-in-class blockchain innovations, with the mission of enabling the next bound of Web3 through open-source blockchain research and development.
Birthday Research’s work spans cryptographic research, deep blockchain consensus development, and smart contracts development — with a laser-sharp focus on pushing the industry frontier while tackling the most demanding DeFi challenges of today.
