The Bracket Protocol was created to specifically address the limitations specific to blockchain as the underlying infrastructure. In this post, we will go deeper into some foundational concepts and the unique pricing methodology of brackets. Because blockchains take time to periodically confirm a new transaction and transactions can fail, we need a way to make a funder’s offer price resilient to market swings and not require frequent updates. Further, since our goal was to keep bracket pricing on-chain, we need resiliency to reduce the number of pricing updates to control the transaction gas costs for funders. By the end, we hope you come away with an understanding of how Bracket Protocol’s pricing is set and how it creatively addresses the need for price resiliency.
Foundations
First, let’s look at some basic options concepts to help us understand the strategies underpinning brackets.
An “option” is a contract that gives the buyer the right but not the obligation to buy or sell a quantity of a target asset like Bitcoin. The “strike price” of an option is the price at which an option is exercised. The strike price is the price at which an option can be sold in the case of a put and bought in the case of a call. Options have uniform expiration dates and strike prices. Further, an option’s “premium” (cost), “term” (time remaining), and how in-the-money the option is depends on the spot price, which is the current market price to buy the underlying asset.
When you think an asset will go UP in price above the strike price within a term, you can use a “call,” or the right but not the obligation to buy a specified amount of an asset at a certain price. So you buy low at the strike price and then sell high at the spot price. When you think an asset will go DOWN in price more than the strike price within a term, you can use a “put,” or the right but not the obligation to sell a specified amount of an asset at a certain price. So you have a pre-committed buyer at a high price, and you can then buy low at the spot price. To actually make a net profit, you also need to consider the cost you paid to buy the option.
The seller (or writer) of the call or put is hoping the underlying asset will change minimally and any payout they must make to the buyer is less than the amount of premium they received.
Looked at another way, the option buyer is hoping for high volatility and the seller is hoping for low volatility.
Bracket Goals
Bracket’s goal was to build a DeFi-optimized product that was resilient to frequent offer-price changes and deliver the following:
- Allow buyers to get highly leveraged exposure (10x to 100x) to asset price movements, where…
- Any potential payout is fully collateralized and backed by stablecoins so the buyer can always get their full payout, but…
- Also be capital efficient for the funders of brackets
Traditional options rely on constant repricing as the spot price moves relative to the strike price, and the expiration nears. TradFi firms have fast computers and a dedicated network to affect these pricing changes in (near) real-time. Anyone who has worked with blockchain knows that it’s getting faster but it definitely isn’t instant! Prices may change rapidly during periods of slow and intermittent connectivity, so to accomplish our goals Bracket Protocol needed to create a way to make its offer pricing resilient to asset price changes.
Goal #2 above has now become top of mind for many buyers that didn’t get the payouts they expected in the last market downturn. Buyers of DeFi perpetual futures and options found that when the market became imbalanced, the winning side of the trade began to be auto-liquidated, and did not receive their full expected payout. This is because wallets have unknown owners and there is no way to go back to them and force the deposit of additional margin collateral. In Bracket, we address this by fully collateralizing the maximum loss, which is a viable funding strategy since the maximum potential payout is limited to a reasonable range.
How Brackets Offers are Priced
To create offer pricing resiliency, we looked at the main drivers of option pricing, which are:
Distance from spot to strike price
Distance from the current price of the asset in the market to the strike price of the option
Remaining term
Duration of the contract remaining until expiration
Risk-free rate of interest
Risk free rate of return is the theoretical rate of return received on zero-risk assets (think the yield on government bonds). This is a rate that many investors use to assess their cost of capital.
Expected volatility
The amount by which the price of an asset will fluctuate or has historically fluctuated. The volatility assumption is the key discretionary input when pricing options. While you can measure historical volatility over a period of time, what really matters is what you forecast future volatility will be over the term of the option.
Bracket Solution
Our solution was to make the distance to spot and term constants so the only variable that may change periodically is the expected volatility. This is achieved by NOT having uniform expiration dates and strike prices but instead, based on time of purchase. So a 7-day bracket expires exactly 7 days worth of seconds from the moment of purchase. Similarly, the strike price is expressed as a percentage above or below spot, evaluated at the moment of purchase.
In TradFi Options, the options price offer must constantly change because every second the option price offer is losing time value as it gets close to the fixed expiration date. Similarly, as spot prices change, the percentage distance “out of the money” of spot vs strike price constantly changes. Notice in Bracket, these are both engineered to be constants. Lastly, the risk-free rate also changes slowly, and over a short period of time, it remains relatively constant (very low volatility).
So the only variable that is not a constant is expected volatility, but… by definition is a period-based measure, so it should not vary too frequently. So to summarize, a funder’s offer price should not require updating unless their view of expected volatility has shifted.
For Bracket Protocol, we chose to fix the premium as a ratio of the bracket width, to have consistent maximum payoff multiples (e.g. 5x, 10x, 20x, 100x).
In TradFi, controlling the options offer structure is the function of the options exchange, they set the allowed assets, option expiration dates, and strike prices. Similarly, Bracket controls the structure of the offers in terms of:
- Premium percentage (e.g. 2%, 1% or 0.5% of spot price)
- The “bracket width,” which is the distance between the strike price when the bracket begins being in-the-money and the maximum claim price. (e.g. set to 10% of spot price)
- The term in seconds from the time of purchase (e.g. 15 days of time in seconds from the moment of purchase until expiration)
- The assets allowed, we only allow assets that have high-quality on-chain oracles to reduce the potential price manipulation.
So with options, premium pricing varies so the key buying decision is if the amount of premium charged is attractive. With Brackets, since premium is fixed, the key buying decision is how far out-of-the-money is still attractive.
Creating a Bracket
So how do we apply these fundamentals?
We named our product “bracket” because the payoff has a bracketed range of price exposure. A bracket is similar in payoff to an options-spread strategy. An options-spread is a strategy frequently used in options trading and is created by the simultaneous purchase and sale of options in the same asset but with different strike prices. Let’s see how we apply this strategy to Bracket Protocol:
In Bracket Protocol a LONG bracket pays off like a bull call spread, which is one long call with a lower strike price and one short call with a higher strike price. A SHORT bracket pays off like a bear put spread, which is one long put with a higher strike price and one short put with a lower strike price. These strategies allow investors to take advantage of moves to the upside or downside without risking more than their premium paid and, if sold by the same funder, cap the maximum potential loss of the funder. As each bracket has a width (e.g. 10%) and the premium is fixed as a ratio to that width, long and short brackets can have offers with fixed payouts, e.g. a 0.5% premium on a 10% width bracket is a 20x maximum claim (10% / 0.5%).
To execute this strategy with options, the buyer would need to establish a margin account and pledge collateral to sell options for the second leg of the strategy. Further, as the options prices constantly change, so do the potential payoffs.
In sharp contrast, Brackets are packaged products, purchased as one transaction, require no margin account, and offer clear fixed maximum-payoff multiples. We wanted to make it super easy to get exposure to an attractive max payoff without the additional complexities of trying to build or compute the strategy yourself. Buyers can easily get exposure to a rise or fall in asset price without the difficulties of writing options. Further, because capital is limited to a maximum potential loss (usually 10% bracket widths), it is capital efficient for funders.
So what does this mean for funders of these brackets?
As mentioned, the bracket width divided by the premium percentage creates the maximum pay-off with fixed multiples. So a 2% premium on a 10% width gives a 5x payoff, a 1% premium on 10% width gives 10x, and 0.5% premium on 10% width gives a 20x payoff.
Within these constraints, the Funders can choose to make offers. So based primarily on the volatility at which the Funder would like to price, they set the starting point of the bracket as a percent premium or discount to spot. They provide funding by making USDC available for brackets (10x, 20x, 50x etc.) for their desired assets (BTC, ETH, BNB etc.), long or short.
In the example below, you can see our Funder pricing screen and how funders can set their starting point as far out of the money as they deem appropriate, meeting or beating the market. Offer percentages are 0.1% increments on brackets.
Simplifying strategies for an easy buying experience
As a buyer of brackets, this means you can buy leverage with a low minimum investment and get a high multiple exposure to fixed potential payouts without risking more than your premium. All you have to do is decide if the asset you choose could be within the bracket range during the term. If so, that bracket may be worth buying.
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— The Bracket Team
