How to use DeFi Option Vaults (DOV): risks and return

Andrey Belyakov

Published in

Coinmonks

7 min readFeb 24, 2022

“DeFi option vaults” can be extremely risky or extremely powerful instrument

This article is a personal view, not a financial advise

Intro

There have been lots of discussions recently regarding DeFi option vaults (DOV); some people argue it is an amazing instrument, while others are completely scared thinking that it is an instrument to only lose your money.

The truth is somewhere in the middle. Let's try to figure it out…

Spoiler: DeFi option strategies are a great way to amplify the yield on your market positioning, but not a passive return instrument.

Normally professional traders and fund managers are using this type of strategy in a combination with their market positioning. Options (as well as derivatives in general) are great instruments to add or remove the risk on your portfolio, but very often they are not meant to be outright positions.

Insight 1: combine options with your portfolio or trading strategy.

The key is to align option strategy or automated vault to your view that eventually will add risks that you are willing to take improving risk/return and capital efficiency on your portfolio. No risk means no return, but what is considered to be a risk for one person may be an opportunity for another person (example: holding cryptocurrency; some people would say it is extremely risky and some people would love to hold it in large amounts).

Let’s consider a simple example: If I have a strategy of holding ETH for long (#hodler strategy) I could also consider a strategy of “smart #hodler”. This strategy would take into account my personal belief that there is opportunity in crypto volatility.

I would like to i) buy ETH every time is significantly dropping too much and ii) I would like to sell ETH if it goes up too fast. In the first case, I believe that ETH will recover and I can sell part of it more expensive or hold for a longer-term otherwise. In the second case, I believe I can buy ETH back as it is likely to correct down, but even if it’s not I am fine selling a little bit at a high price.

In this example options can perfectly help me. Every week I can write a call option to sell part of my ETH if it goes 35% up within a week. At the same time, I can write put options to buy ETH if it goes 35% down within a week. By doing so, I receive premiums two times. Even if my options are never executed my capital can earn 10–20% APR. Looks nicer than using limit orders and it can also discipline me to follow chosen strategy (most of the people are afraid to buy at lows and regret later).

The major difference from limit orders is that call options will be only executed if the price stays high/low on Friday morning (8 am UTC is a global option settlement for many CeFi and DeFi markets). So, if the price dropped dramatically on Wednesday and come back on Thursday nothing will happen, while a limit order would have been executed. This has pros and cons.

Wrong usage of DOVs

There was a lot of criticism due to some liquidations on Ribbon recently, people were losing money quite fast.

No one should think that option writing strategies are a source of passive income, where you plug assets and get a free return. Again, you should be ready to potentially execute options without hard feelings.No-one should think that option writing strategies are sourse of passive income

Insight 2: Never trade option if you don’t understand all underlying risks and mechanics. One can lose all the funds with it.

I would say again, using DOVs for passive return is a wrong concept. There are normally two ways options can be settled — physical delivery or cash settlement. In the first case you will actually trade your underlying asset, but in the second case (that is more popular) you will need to buy or sell your asset yourself on maturity (on Friday morning) when you receive just enough funds for such trade from DOV.

Example: you are participating in the vault that writes put options, let’s say you stake 2000 DAI and are willing to buy ETH if it drops from the current price of 3000 within a week. [actual numbers from existing vault right now]

If ETH cost 1900 DAI on Friday morning you “have sold” it for 2000 as agreed, congratulations. You should get 1 ETH instead of your stake, but you will be DAI settled. You get 1900 DAI from the vault (equal to 1 ETH at the market price of 1900 DAI), so it is the exact amount to convert to 1 ETH, but you have to do it yourself on Friday morning.

Some vaults [Opium 2.0 will have a feature of physical delivery, but as long as I know all DeFi vaults and most traditional derivatives now have cash settlement mechanisms].

Simple strategies

*not a financial advise, also note that opium.finance is not allowed for US person or other prohibit jurisdictions*

These simple strategies are already implemented in DeFi by a few projects, let’s look closer.

Covered call

Combines holding of the underlying with writing a call option on the high price. As discussed earlier suits investors, who are willing to sell when the market goes up too much.

There are few implementations of this strategy, at Opium, for example, it’s fine-tuned to algorithmically choosing a strike price as far away (but still liquid) from the spot as possible (to minimize the risk and used 2x leverage to optimize for risk/return and capital efficiency). The opium community chose these parameters over lower strikes to minimize the risk of execution and also believing that this fits the idea “I want to sell if it moves really high”.

Outright short put

Direct order to buy asset if the market drops too fast with extra yield every week.

Opium community implementation has a similar idea — algorithmically choosing a strike price as far away from the spot as possible (to minimize the risk and used 2x leverage to optimize for risk/return and capital efficiency). The opium community has chosen these parameters over lower strikes to minimize the risk of execution and also believing that this fits the idea “I want to buy if it moves low”.

Spoiler: Some advanced strategies

Options allow for fine-tuning your exposure based on your risk profile. There are typical strategies people use in financial markets, let’s look at a few. Our community builds them as a part of Opium 2.0. The full analysis of such strategies will come shortly in the separate research article.

The full analysis of such strategies will come shortly in the separate research article

Short strangle — fixed upside, unlimited downside

You profit from little or no price movement in the underlying asset.

Long straddle -unlimited upside, fixed downside

You may have unlimited profit from both upside and downside moves (long volatility).

Covered collar — fixed upside, fixed downside

Insure you asset from large movements either side (insurance from drop is sponsored by giving away upside, i.e. writing a call)

It is equivalent to covered call strategy adding protective put (that will cost yield).

Current DOVs

There are currently some Differences in assumptions and they differ mostly in implementation.

They have their pros and cons, some focus on the high deltas (strike price is close to current spot price), but few focus on lower deltas (strike price is far away from the current spot).Stay tuned

Opium Protocol is a universal and robust DeFi protocol that allows for creating, settling, and trading decentralised analogues of derivatives.

Explore Opium Protocol or try out Opium Finance

Stay informed and follow Opium.Team on Twitter.

Did you know that you can subscribe to our News Channel to get more exciting news delivered to your morning coffee?

** Subject to Terms and Conditions *** not financial advise and prohibited for some jurisdictions***

Join Coinmonks Telegram Channel and Youtube Channel learn about crypto trading and investing