Charm
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Charm

Mainnet enhancements

First of all, a massive thank you to everyone who tried our testnet! We have worked through your suggestions, and implemented substantial enhancements ahead of Charm’s imminent release on mainnet. The purpose of this article is to walk you through the key changes — these are:

  • Included easy-to-understand descriptions to help you manage your investments.
  • Introduced more capital efficient ways to provide covered calls.
  • Introduced slippage warnings to indicate overpayment.
  • Created separate pages to open and close options exposure.
  • Only display calls and puts in the front end, whilst preserving the ability to buy covered calls.
  • Included dropdown menus to help you find a particular option.
  • Added support for a TVL cap for each contract.

These enhancements offer a number of benefits such as:

  • Liquidity provision is more capital efficient.
  • Buying and selling options are even easier.
  • Easy ways to manage risk and reward.

Charm’s mainnet can offer these additional benefits, without compromising its ability to supply cheaper options and higher profits for traders, and safer yields for Liquidity Providers (LPs). All these benefits are summarised in the infographics below:

The following sections provide more details on the additional benefits.

Changed our protocol from LS-LMSR to LMSR

The only technical difference between LS-LMSR and LMSR is that the liquidity parameter (i.e. ‘alpha*(q1+q2)’ in our Litepaper) in the LMSR price function is a constant; whilst for LS-LMSR, it is a variable that depends on the total open interest of all the options. The implication of this change is that option markets using the LMSR need much smaller amount of seed liquidity to perform at a desired slippage level, and this amount can be calculated before a market opens.

Once the seed liquidity has been provided, any markets powered by the LMSR will retain all the key benefits described in our previous articles, on top of offering the following additional benefits:

  • Prices determined by the LMSR respond to absolute changes in the quantity of options purchased, rather than changes in the ratios per the LS-LMSR. This means changes in slippage under LMSR will remain constant throughout the life of an options market, regardless of the trading volume. This additional certainty will be more conducive of an efficient/competitive market, which means trading options on Charm can be even cheaper and/or more profitable.
  • LPs have the same worst-case losses for LS and LMSR, but the LMSR requires less capital for the same exposure. For example, an LP supplying $100 of liquidity under LS-LMSR has a worst-case loss of 5% or $5, and this is equivalent to supplying $5 under the LMSR with a worst-case loss of 100%. An AMM using LMSR can therefore provide a more capital efficient way to contribute seed liquidity, and this will facilitate the creation of more option markets for any given amount of seed liquidity.
  • The LMSR cost function can calculate the exact amount of seed liquidity required to operate at a desired level of slippage — this means a single pool of funds can bootstrap multiple markets at the same time, and these markets can function immediately at a desired level as soon as it opens for trading.

The key drawback of the LMSR is that compared to the LS-LMSR, slippage under the LMSR do not improve as open interest increases. This is because the liquidity parameter (aka ‘b’) is a constant, and option markets with a small ‘b’ will require less seed liquidity, but will operate at a higher slippage if the trade volume is low. The opposite will apply for large b.

The innovations we have described in v0.2 overcome the drawback described above. This is because for both LS-LMSR and LMSR, slippage improves as the amount of liquidity provided to a market increases; and v0.2 pools liquidity provision across multiple option markets so that for each market, there is more liquidity to lower the slippage, even though the actual liquidity provided is low. This means even at low trade volume, a combination of LMSR + v0.2 will retain all the benefits of LS-LMSR, in addition to having a sufficiently low slippage to supply cheap and high-quality options.

Introduced more user friendly interfaces

To make options ownership simple and intuitive, we have re-engineered our user interfaces so that it is even easier to buy, sell, and redeem options. The enhancements are summarised below:

Created separate web pages to open and close options exposure

‘Trade Options’ will open an exposure; whilst ‘Manage Options’ will close an exposure, and/or collect any payoff after the expiry date. This approach is similar to Uniswap, and other popular trading apps such as Robinhood and Interactive Brokers.

Only display calls and puts on the front end

The mathematical identity used by our AMM implies that selling a call or put is the same as buying a covered call. Therefore, it is possible to only display calls and puts in the front end, because exposure to covered calls can always be opened in ETH by selling a call option, and in USDC by selling a put option.

Introduced slippage warnings to indicate overpayment

Even though slippage (or price impact) can be useful for price discovery, there are situations (eg low trading volume, high volatility) when users may overpay due to high slippage. To prevent this, we have included a slippage indicator whenever the prices are +/- 10% from the last purchase price, so that users can make an informed decision before placing a trade.

Included dropdown menus to help you find an option

All the option markets available on Charm can now be filtered by underlying, expiration date, and strike price; which means no complex tables are required to find the options you want.

An added benefit is that it is now much easier to arbitrage between Charm and other platforms (eg Deribit). This will be discussed further in a future article.

Included easy-to-understand descriptions to help you manage your investments

Options can appear complex, but they don’t have to be. If used properly, options are one of the most effective, and most responsible ways to grow your wealth.

To help users manage their risk and reward, we have provided a summary of the risk and reward profiles of all options available at Charm:

Buying ‘Call’ and ‘Put’ normally have a higher risk and reward profile than buying ‘Sell Call’ and ‘Sell Put’. The profile of each option can be adjusted by changing the strike price (eg calls with a lower strike price are less risky than the same call with a higher strike price)

We have also provided easy-to-understand descriptions in our mainnet interface, so that when users buy an option, they will understand exactly what was bought, what are the possible gains, and the risks.

Some numerical examples* are provided below.

*Assume the market price of ETH is $1000 for all examples.

If you think the price of ETH will be above $800 on 20th Jan 2021…

…you can get 2 call options with a strike price of $800, at a total cost of 0.2 ETH and a price of 0.1 ETH per call option.

Charm will tell you that:

You’re buying 2 ETH calls, which means you think the price of ETH will be above $800 on 20th Jan 2021.

You have now ‘bought’ 2 ETH for only 0.2 ETH — i.e. at a 90% discount! The payoff chart for call options indicates you will gain if the market price of ETH is above $800 on 20th Jan 2021.

You’ll break even at expiry if price of ETH is $900.

The gains above do not include the total cost to purchase the call options, and to break-even, the actual gains will need to be higher to recover this cost. Your cost will be fully recovered if the ETH price is 0.1 * 1000 + 800 = $900.

Your maximum gain is unlimited, but your option will expire worthless if price of ETH ends up below $800.

You will be exposed to the price movements of 2 ETH, and your maximum gain is unlimited because there is no limit to how high ETH prices can go in USDC. However, if the price of ETH is below $800 on 20th Jan 2021, you will lose 0.2 ETH (i.e. the price you paid for the options).

For call options, your biggest risk will be losing your entire premium (or total cost); but this is often lower than the loss you would have incurred if you bought 2 ETH directly instead of 0.2 ETH call options.

You can close your position for its market value at any time before expiry.

You can close your position for an immediate gain at any time before expiry, if the market price of an option is higher than the price you bought it for (i.e. 0.1 ETH).

If you think the price of ETH will be below $800 on 20th Jan 2021…

…you can get 2 put options with a strike price of $800, at a total cost of 50 USDC and a price of 25 USDC per put option.

Charm will tell you that:

You’re buying 2 ETH puts, which means you think the price of ETH will be below $800 on 20th Jan 2021.

You have now ‘shorted’ 2 ETH for only 50 USDC — i.e. at a 97.5% discount! The payoff profile for put options indicates you will gain if the market price of ETH is below $800 on 20th Jan 2021.

You’ll break even at expiry if price of ETH is $775.

The gains above do not include the total cost to purchase the put options, and to break-even, the actual gains will need to be higher to recover this cost. Your cost will be fully recovered if the ETH price is 800–25 = $775.

Your gains are capped and your option will expire worthless if price of ETH ends up above $800.

You will be exposed to the price movements of 2 ETH, and your gains are capped at $800 per option, which will only happen when the price of ETH falls to 0. However, if the price of ETH is above $800 on 20th Jan 2021, you will lose 50 USDC (i.e. the price you paid for the options).

For put options, your biggest risk will be losing you entire premium (or total cost); but this is often lower than the loss you would have incurred if you shorted 2 ETH directly, or if you owned 2 ETH and did not buy put options to protect against the downside risks.

You can close your position for its market value any time before expiry.

See the example for call options.

If you have ETH and believe ETH prices will not rise above $1200 on 20th Jan 2021, but cannot afford to lose your entire premium…

…you can get 2 ‘Sell Call’ with a strike price of $1200, at a total cost of 1.8 ETH and a price of 0.9 ETH per ‘Sell Call’.

Charm will tell you that:

You’re selling 2 ETH calls.

This is the same as buying 2 ETH covered calls (see earlier section) using 1.8 ETH. This means you have exchanged 1.8 ETH for 2 ETH, provided you agree to sell it for $1200 on 20th Jan 2021.

You’ll get a yield of 11.1% in ETH if the price of ETH is below $1200 on 20th Jan 2021, but will miss out on gains if ETH price rises.

As described in a previous article, the total price of an ETH call option and a covered call with the same expiration and strike price, is always equal to 1 ETH. On expiration date, if the price is below $1200, ETH call option will expire worthless with a price of 0, which means the cover call will have a price of 1 ETH. The covered call will therefore have a guaranteed yield of (1–0.9)/0.9 = 11.1% in ETH.

On expiry, you will receive ETH with an average price of $1200 per ETH, even if the market price is above $1200. Therefore you would have missed out on gains above $1200.

In contrast to put options (which also profit if the price does not rise above a certain level), the price of covered calls is much less volatile, and it is highly unlikely you will lose your entire premium (i.e. the total cost) because this will happen only if the price of ETH collapses to 0.

You can close your position for its market value any time before expiry.

See the example for call options.

If you have USDC and believe ETH prices will rise above $1200 on 20th Jan 2021, but cannot afford to lose your entire premium…

…you can get 2 ‘Sell Put’ with a strike price of $1200, at a total cost of $2000 at a price of $1000 per ‘Sell Put’.

Charm will tell you that:

You’re selling 2 ETH puts.

This is the same as buying 2 ETH covered calls (see earlier section) for $2000. The outcome is that you have exchanged $2000 for the opportunity to earn $2400, provided you agree to the downside exposure if ETH prices falls below $1200 on 20th Jan 2021.

You’ll get a yield of 20% in USDC if the price of ETH is above $1200 on 13 Jan 2021, but will be exposed to losses if ETH price falls.

As described in a previous article, the total price of an ETH put option and a covered call with the same expiration and strike price, is always equal to $1200 (the strike price). On expiration date, if the price is above $1200, ETH put option will expire worthless with a price of 0, which means the covered call will have a price of $1200. The covered call will therefore have a guaranteed yield of (1200–1000)/1000 = 20% in ETH.

On the other hand, if the price of ETH is below $1200 on expiry, you will be exposed to losses.

In contrast to call options (which also profit if the price rises above a certain level), the price of covered calls is much less volatile, and it is highly unlikely you will lose your entire premium (i.e. the total cost) because this will happen only if the price of ETH collapses to 0.

You can close your position for its market value any time before expiry.

See the example for call options.

Other enhancements

A number of other enhancements have been made to improve capital efficiency, and to increase security:

Introduced more capital efficient ways to provide covered calls.

In v0.2, we’ve described how covered calls with different strikes in USDC can be provided using a pool of puts, covers, and bear spreads. The covered calls that can be provided using this pool have the expected payoff profile, but are less capital efficient. This issue is described further in the following diagram:

Under the old pool containing bear spreads (upper diagram), the covered calls that can be created by this pool do not start at 0 (lower diagram). It is therefore not capital efficient because the pool needs to lock up more funds than necessary to provide covered calls.

To address this issue, a small tweak was made to the payoffs of the bear spreads to turn it into ‘triangular spreads’; so that a pool of puts, covers, and triangular spreads, can now provide covered calls in a capital efficient manner. This is illustrated below:

The new pool contains ‘triangular spreads’, which can be used to provide covered calls with payoffs that start from 0. This increases capital efficiency because no unnecessary funds need to be locked up to provide covered calls.

Added support for a TVL cap for each contract

We want to offer the full benefits of Charm to users as early as possible, but understand that in the earliest days of any protocol, there is a high risk of economic hacks, bugs, oracle manipulation, etc. that can lead to users losing 100% of their funds.

In order to protect our users, we have implemented a TVL cap so that the maximum amount of funds held by the AMM for each market is capped. These limits will be gradually lifted as more security enhancements are put in place - such as getting an insurance, launching bug bounty programs, and getting security audits.

What this means in practice is that, when the TVL limit is reached, users will not be able to open any more positions until someone else closes it, and vice versa. It will not affect the pay-offs on expiry, nor the ability to sell options at any time before expiry. In addition, the TVL limit may not have an impact on price discovery because if for example, the price limit for calls has been reached after users have bought lots of calls, it can still increase further if users close their positions in ‘Sell Call’.

Conclusion

So there you have it, we have introduced further enhancements to help users benefit from cheap options, predictable gains and yields, simple ways to trade options, and better ways to manage risk; and these benefits will be the same for everyone, regardless of whether you are a seasoned investor, a professional trader, or a crypto inductee.

These enhancements and our mainnet, will go live very soon. We want everyone to take part at the earliest opportunity and as such, we will be making simultaneous announcements on our official channels as soon as we launch.

We are grateful for everyone’s support, patience, and understanding, as we navigate the final stretch toward our first significant milestone. We feel truly blessed to go on this journey with all of you, and can’t wait to show you the culmination of our efforts over the last few months…

: )

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