A Deep Dive into Options Products in DeFi
Understanding the popular DeFi products offering 20–30% APY
There is a collection of new products that are gaining popularity among DeFi users. They offer a unique kind of yield with a risk profile different from what yield farmers or stakers are used to by providing access to options premiums without having to deal directly with options. These protocols use a combination of different options and pack them under a strategy, which is offered directly to the user. These kinds of strategies fall under the category known in traditional finance as structured products.
Structured products are financial instruments that are packaged and offered to users the accessibility to a set of complex strategies based usually on derivatives. In the case of DeFi, the most demanded ones are based on a combination of options buying or selling. For those unaware of what options are, these are derivatives based on the value of underlying assets such as BTC or ETH. An options contract offers the buyer the opportunity to buy (calls) or sell (puts) of the underlying asset. The payoff depends on the strike price chosen on each option. Nowadays there are decentralized options protocols that are used extensively such as the following:
Decentralized options markets are the inner layer that allow the design of the structured products that we will cover today. These products are very innovative since they offer a unique kind of yield that does not come from token issuances, asset lending or trading fees, but rather from earning a premium for selling call or put options.
Their risk is minor relative to vanilla options strategies, but yield could be negative based on price action, so certainly they are not risk-free assets. For DeFi users, this is the easiest and most accessible way to obtain these yields without having to fully understand the intricacies of options such as the greek parameters or complex hedging strategies. The protocols with the most traction that offer such structured products are:
Ribbon
Arguably Ribbon Finance is the most popular protocol for structured products exclusively based on options, with a TVL exceeding the $200M. Operating in Ethereum, they are offering 6 different vaults with a wide range of assets such as USDC, wBTC, ETH or AAVE. They use both covered calls and put selling strategies extensively. Not long ago their vault capacities were constantly full, but have now been expanded up to 8 and 9 figures in most vaults, making up a sizable share of the total options market.
Their most recent vault based on stETH is an interesting combination leveraging the power of composability in DeFi. Another consistent source of yield is liquid staking, which can be used as collateral for writing options so it compounds even a greater yield. Other vaults use common assets as stablecoins (USDC), or ETH or wBTC:
The options market bought in these strategies are coming from the Opyn protocol. The fees charged to users by the protocol are 2% annualized management fee and 10% weekly performance fee. If the weekly strategy is profitable, the weekly performance fee is charged on the premiums earned and the weekly management fee is charged on the assets managed by the vault. If the weekly strategy is unprofitable, there are no fees charged.
Currently these fees accrue towards the DAO treasury, but an upgrade is in the works for these fees to accrue towards Ribbon token stakers. The plan is to direct the token emission towards certain vaults depending on what stakers vote on, similarly to how Curve gauges work. Interestingly these fees could also be used to mitigate large market downturns that could negatively impact the strategies.
StakeDAO
StakeDAO offers a range of several different products that go beyond those based on options. They are also in Ethereum. Interestingly their projected yields are higher than those offered on Ribbon because they combine these strategies with their other passive strategies based on liquidity mining rewards and trading fees. Another example of a great use of composability in DeFi. Their strike price selection seems equally conservative as those in Ribbon, and it is also updated weekly. Among all their strategies these are the ones based on options:
The underlying protocol selling the options is also Opyn protocol. Their fee structure in these options based strategies is a standard 0.5% withdrawal fee and none based on the performance of the strategy, which gets distributed among protocol token holders that are staking, similar to Sushiswap’s staking rewards methodology. Here are the strategies offered based on options:
It is out of the scope of this article, but is interesting how they combine NFTs with premium access to some of their other strategies. This makes sense in the case of strategies such as arbitrage, that have a very limited capacity.
Dopex
Dopex has been the most recent popular protocol to offer these option vaults, called SSOV (single stake option vaults). These have several differences to the ones seen on Ribbon and StakeDAO. Primarily they issue their own options using an unique architecture that employs a combination of protocols such as UMA or Sushiswap to hedge the contracts sold. They are currently running on Arbitrum, so mitigating the gas fees of mainnet. They rebalance monthly instead of weekly, and the strike price can be chosen among three options by the users.
Since the strike price is selectable, the risk exposure is up to the user. Strike prices closer to the actual price will give higher yields at the expense of higher risk, while strike prices chosen further than the actual price will offer less yield but less risk. The three vaults that are offered are:
The fee structure of Dopex involves charging a fee of 0.125% (0.25% for rDPX) of the underlying amount which gets distributed towards the liquidity pool and the staking pool, so token stakers can benefit from the usage of the protocol.
Options strategies employed
The main economic risk for users deposited into options vault is if the price of the asset varies such as the call options expire resulting in a loss for that period. Since strike selection is critical, protocols have the objective of having a conservative risk profile by trying to select strike prices that avoid losses and maintain the strategy as profitable as possible. In our experience, the strike prices chosen correspond to price levels generally around 25% above the current price. The fact that this strike price is chosen permissioned (off-chain) instead of automatically leaves some concerns. For example a fault could happen if there is any mistake while choosing the strike, or somehow a malicious operator could be in charge. This could incur a huge loss for a vault. So far this has never happened and chances are low, but it is worth pointing it out. The benefit of a manually adjusted strike price is the flexibility of the protocol to adapt to market conditions not experienced yet that might highly alter the current yields. Maybe an idea to explore in the future could be strike price selection chosen algorithmically based on implied volatility index fed by an oracle.
Back to the mechanics, these vaults function differently than most other DeFi vaults, where assets can be withdrawn any time. Once user funds have been used in the vault’s periodic strategy they cannot be withdrawn until the vault closes it’s position (either weekly or monthly, depending on each protocol). Users can withdraw their funds instantly during the timelock period where the vault closes its previous position and opens its new position. This period lasts usually several hours.
Covered call
The strategy generates yield by combining spot asset buying and option selling. It automatically sells out-of-the-money call options and covers the position by locking the equivalent asset collateral’. The strategy receives a premium in return for selling options, which is added into the strategy and compounded, producing an annual percentage yield. This can be easily understood with the next chart, where price variation is plotted in the X axis while profit and loss is represented in the Y axis:
The goal for the strategy is that the options sold each week expire worthless, allowing to earn the option premium while maintaining exposure to positive asset upside. The strategy has a higher chance of success when large price increases are not expected during the period that the vault is active. It could be a good complement to a market with extended bear sentiment or moderately bull price action. The profits for each situation can be easily simulated with the Ribbon profit calculator:
The primary risk for running this covered call strategy is that the vault may incur a loss in the case where the call options sold by the vault expire above the strike price of the call options minted by the vault.
Put selling
The payoff profile of put selling strategy is the opposite of a covered call.
The strategy is best suited in flat or ranged markets. Upwards-trending or moderately declining market conditions can be the best use cases. As an example of when things go south, the Ribbon ETH Put Selling vault lost -12% of its value during the May correction this year.
The main risk for users in a put perpetual vault is if the put options expire below the option strike price, resulting in a loss for that period. If the options expire in-the-money, the loss is equal to the difference between the strike price and the settlement price. Vault depositors keep the yield from option premiums, but the loss incurred is taken from the collateral deposited.
Risk profile, counterparties and capacity
These strategies are profitable because historical weekly returns of most investing assets tend to follow a normal distribution. Although in equities and cryptocurrencies the price action has been slightly asymmetric towards the positive side so far, since both of them have been historically increasing in price over time. One can take advantage of this behavior by betting on returns that will fall likely around the center of the distribution instead of the tail values, since these are way less likely to be achieved. This is what is often called an asymmetric bet. The distribution of weekly BTC returns can be see on the next chart:
For example, by betting every week that the returns will not exceed 0.25 a trader could be earning yield most weeks. The products that allow traders the exposure to this kind of strategies are a combination of options.
Regarding the counterparty, or who is on the other side selling or buying the options that these strategies use, the reply is usually market makers. Other traders engage in selling these options for example in Opyn while market makers bid via an auction to be the counterparty buying the options. These market makers hedge their risk by buying either the asset on the spot market, or positioning themselves in futures contracts. This is a common technique used extensively in traditional markets that allows to stay delta neutral, so not exposed to the price action of the underlying, and still collect the premiums or spreads. Ribbon V2 uses open auctions via Gnosis while StakeDAO uses Airswap to sell to a list of whitelisted market makers. Dopex directly issues the options by themselves. These auctions are offered at a better price than centralized options exchanges such as Deribit, so market makers have the opportunity to arbitrage between them as well.
Regarding the capacity of each strategy, since the liquidity that these market makers and other traders provide in the options markets is limited, the capacity that the reviewed vaults offer is also capped. If the popularity of these products continues to grow it could be expected that the liquidity that the options markets are seeing would grow as well.
Another tool in the box
At IntoTheBlock we hope with this article to have helped users understand the expected returns in these products, the economical risks involved and how the products work behind the scenes. We believe that the simplicity and composability that these products offer will attract greater capital both from retail and institutional investors alike.
