How to Trade Crypto Options on Divergence
Can you trade crypto options in DeFi? Yes, and Divergence is primed to be your go-to decentralized platform in this space. On Divergence, getting in and out of options positions is just like swapping tokens on your favourite DEX. For all their nuances, decentralized crypto options on our platform are simply tokens bought and sold on-chain. This step-by-step guide will show you what options will soon be offered on the Divergence app, how to trade them, and why they matter.
This is the first in a series about trading, hedging, and decentralizing crypto volatility. Our aim is to help you turn volatility in your favor.
Now, let’s dive in.🌊
What are Binary options?
To start, imagine you are buying insurance for your yacht. It sucks to pay a premium every month. Yet, it would really suck if you were to lose your yacht (and those diving trips that come with it). So you pay a premium for the probability of your yacht getting hit by a storm. If it does happen, you get paid by your insurance plan, if not (and hopefully this is the case!) you only lose your premium.
Buying an option — a binary option, to be precise — in a Divergence V1 pool is a similar idea. Binary means there are two probable outcomes. When you buy a binary option, you are buying a financial contract with an all-or-nothing payout for a specific period. If the terms of the contract are met, you get paid a fixed amount, otherwise you lose the premium you paid.
In the old world, the options payout is usually in fiat currency. On Divergence, a binary options token pays out 1 or 0 collateral, i.e. whatever fungible tokens used to fund a pool.
The binary options tokens on Divergence are called Spear and Shield. Spear buyers make bullish bets on the price or price volatility of a coin. Shield buyers do the opposite. You buy Spear when you think a coin will go up in price, or when you think a coin will break out of a price range. You buy Shield when you think a coin will go down in price, or when you think it will stay within a price range.
Let’s look at these binary options tokens in detail:
Anatomy of a Binary Option at Divergence
So, How to Trade Binary Options?
If you are still with us here you are already halfway through the first step:
1️⃣Step 1: Do Your Own Research
Like trading any token, you would like to buy Spear and Shield low and sell high. The max value for Spear and Shield is 1 collateral. Spear and Shield move in opposite directions. For all the options math formulas, this one is the most important to know:👇🏻
💥1 Spear + 1 Shield = 1 collateral.
This means when you buy Spear, your order will send the Spear price higher and push lower the Shield price. The same is true for the opposite. Market buying and selling decide on the price of these options tokens.
However, buyers and sellers in this market will trade in a different way compared to how they trade spot tokens. This is because they value Spear and Shield as the contractual right for a payout at settlement.
The three main influences on the Spear and Shield value are the price of the underlying asset, time until expiration, and probability. Let’s look at each individually:
1)Current Price of the Underlying vs Strike Price
When you trade on Divergence, you’ll notice that there are many strike prices. These strike prices can be above and below the current price of your chosen underlying asset. Spear and Shield with a strike price that is either right at (or very close to) the current price are called “at-the-money” options. These strikes become either more “in-the-money” or “out-of-money” as the price of the asset rises or falls . “In-the-money” options give you the right to buy or sell the asset at a better price than the current price. “Out-of-money” options are the opposite.
2)Time to Expiration
The more time there is until expiration, the more time there is for an underlying asset to move in price and become “in-the-money” or “out- of-the-money”. Because of this, time means more value for an option. For the same strike price, the Spear and Shield with a longer expiration are more valuable.
3)Probability
How likely is it that Spear or Shield end up “in-the-money” at expiration? This is the essential question to ask because trading options is betting on probability. In general, if you believe the market is under-estimating the probability for Spear or Shield to expire in the money, it is a buying opportunity. If you believe the market is over-estimating the probability for Spear or Shield to expire in the money, it is a selling opportunity.
This is where you can consult your list of options math formulas, which is beyond the scope of this article. For those who are looking for references, we have listed a few books in this section of our documentation. We are not affiliated with any of these authors, so please use your own discretion. Other insightful references are welcome to be shared in our community groups.
2️⃣Step 2: Trade Like a Uber Diver
The hard work is done after you’ve finished the above step. We assure you rest is straightforward.
1)Take Your Bet
Hit that go trade button and punch in your desired amount of Spear or Shield :👇🏻
….and then approve the transaction from your non-custodial wallet.
That’s it. You are done and now own Spear or Shield. According to the terms in the example above, each Spear token you hold gives you the right to claim 1 DAI if BTC/USD settles at or above $35500 on 1 July 08:00 UTC. If BTC/USD settles below $35500 on 1 July 08:00 UTC, each Shield token you hold gives you the right to claim 1 DAI.
To review your options position, look into your dashboard:👇🏻
⚠ If you check your Metamask, you won’t see Spear and Shield tokens. Why? This is because these Spear and Shield are “Virtual Tokens”.
Here’s the deal: Divergence fully tokenizes your options positions as tradable “Virtual Tokens’’. Spear and Shield are not designed to be withdrawable ERC-20 tokens. This is because minting and transferring a new ERC-20 token for every round costs gas, and these costs can add up quickly. With Divergence everything is done “in house” so you save on gas, and don’t have to send your Spear and Shield tokens to another DEX for trading. ⛔ Creating a pool collateralized by Spear or Shield does not work either.😅
2)Book Your Profit
Spear and Shield do not have to be held all the way until expiration. You can trade with the pool as you wish before settlement. If you see a profit when the market moves in your favor, feel free to take it.
Say, for example you bought a Spear for 0.4 collateral, and 30 minutes later a massive pump happens to the underlying asset. Your Spear becomes “in-the-money” and makes a nice 2x in price to 0.8 collateral. Since your max payout is 1 collateral, you decide to exit your position by clicking the sell button here on your dashboard:
And approve this transaction:
Now you can chill in your yacht. But wait, why does this 2x moon happen so quickly? This is because Divergence offers you real-time options price discovery via its AMM model. This is important because you can have a much more efficient marketplace. On some platforms, you have to park your capital in a pool, and wait until settlement to see if your position expires “in-the-money”.
3)Bet Price, and Range
Well, catching a massive pump in the next 30 minutes may take a lot of luck. More often than not you wonder which direction the market is going. Chances are it is going sideways. 😴
Sideways markets can turn out to be interesting for an options trader. It means you can bet on an underlying asset NOT moving out of a certain price range.
On Divergence there are binary markets where you can bet on a price range, or “strangle” markets. Spear holders who are bullish on volatility will get paid if prices break out of a range. Shield holders, on the contrary, will get paid if the underlying settles within this range.
Suppose you are pretty sure that the whales are taking a summer vacation. It’s not clear to you which direction ETH/USD will go but you think it is highly probable that the price will stay between $1600 — $2600 for the next week. In this situation, you can go ahead and buy Shield token. You will make a profit if your prediction comes true.
If a market of these terms doesn’t exist, it is up to you to create one as a LP. If you are right and the market is buying more Spear than Shield from your pool, you get to relax on your yacht with a handsome profit. You are collecting the net options premiums, liquidity provider fees, plus applicable $DIVER incentives.
4)Bet with Any Token
On Divergence V1, each binary options pool accepts an ERC-20 token as liquidity and the same collateral is used for trading. The collateral does not have to match with the underlying asset.
Say, for example, you’re interested in trading ETH-USD options. You can create a pool using a stable coin like USDC, or WETH. Or you can use different versions of staked ETH such as STETH on Lido.
What if you have none of the above and would like to create a pool using YFI? Sure. It is up to you to bet with any token you like. Spear and Shield in this pool would be worth 1 YFI at expiration. We leave the hard questions of how to price these exotic options to you. On Divergence, the users call the shots. 😎
3️⃣Step 3 (optional) : Claim Your Proceeds (if any) After Settlement
If you choose to hold your options position until expiration, your positions will be settled by the smart contract. At any time after the expiration, you are able to claim the payoff.
If you also provide liquidity to the pool, you can schedule an “expiry exit” at any time before expiration. This will remove your liquidity and proceeds upon settlement. You have a choice of removing your liquidity earlier than expiration for a small penalty up to 1%. This penalty is designed to discourage competitive LP withdrawals ahead of the settlement, ie, liquidity “rug pull”.
On some platforms, an options market can be gone once a term expires. LPs would have to take out their liquidity and re-create a market in a new pool. This is not the case with Divergence V1 pools. The markets automatically roll over unclaimed LP collateral in the same pool using identical terms.
For example, you create a pool that has a strike price of $2,000 for ETH/USD and a weekly expiration on 9 July 08:00 UTC. This pool can be rolled over using a fixed strike of $2,000, or a strike calculated using a fixed percentage, i.e. target volatility. If the settlement price on 9 July 08:00 UTC is $2,800 and you use a target volatility of 7%, the strike price of the rolled-over pool would be $3,000.
Cool, But Why Trade Binary Options Again?
Because you already have your skin in the game. Going back to the Yacht insurance example, you are living with the probability of a storm and are hedging against it. If you have exposure to crypto or DeFi, you are living with the probability of getting hit by turmoil in the market. Binary options are an instrument you can use to hedge your DeFi risk exposure. We will discuss this in greater detail in our next article about hedging with binary options.
And if you are looking for profit, trading binary options can be profitable in any market conditions, whether volatile or flat. Such trades can be highly leveraged. When trading binary options on Divergence, the risk-reward is known up-front, and the payoff is non-linear. We hope you will dive deep into options with us. Happy trading!
About Divergence
Divergence is a decentralized platform for volatility hedging and trading with a focus on blockchain native asset prices, value of LP tokens, interest rates, DeFi farming and staking rewards.
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