Comparing the different DeFi option protocols
There are many options protocols in the DeFi space now. As DeFi traders, it is important to understand the differences so that you can use the right option protocol for your needs.
Below is a table comparing the major option protocols. All of them are different in terms of expiration types, settlement, underlying assets, collateral requirements, fungibility, etc. We will dive into what these terms mean and how it might affect your option trading strategy.
American v European Option
For options there are 2 ways to exercise an option.
An American type option allows users to exercise the option before the expiration date.
An European type option only allows you to exercise the option at the expiration date. The valuation for the option should not change much because if there is a liquid market for an American option, no one will exercise before the expiration date because of the time value.
If you are using an option protocol with American type options, you need to be careful since you have to exercise the option before the exercise date, otherwise there is a risk that the option expires worthless.
Lien option type is European. If the option is in the money at expiry, the option is cash settled and users need to claim the payoff if the option is in the money.
The underlying assets of options
The more variety there is of the underlying assets of the options, the better it is for traders because they have more options. Most option protocols are adding other assets besides ETH.
Lien has recently added BNB as an underlying asset for options on Binance Smart Chain.
Traders can trade BNB call options and exotic options such as butterfly options.
Lien’s integration on Binance Smart Chain
Lien will be creating a Crypto-Naitive Option Protocol using Binance Smart Chain.
Lien will continue to support various cryptocurrencies as underlying assets of options.
Cash v. Physical Settlement
There are two ways to settle an option payment, cash and physical. In cash settlement, users receive the payoff of the option without having to deliver the underlying asset.
For example, If ETH trades at $2,000 at expiration and the strike price is $1,600, then the holder of the call option l receives $2,000-$1,600=$400. The holder does not have to deliver ETH to the call option writer.
On the other hand, if the option is a physical settlement type, then the holder of the call option has to deliver ETH to the call option writer and then receive $2,000.
Cash settlement is less capital intensive for the option holder because the trader does not have to deliver ETH to the seller of the option.
Options on the Lien protocol are cash settled so traders do not have to deliver ETH on the expiration date, which is better for capital management.
As you can see from the table the collateral type is protocol dependent. Most protocols have ETH as collateral but some have USDC or DAI as collateral.
For put options, the protocol needs a stablecoin as collateral so that the pool is always able to pay out put option buyers.
For Lien Protocol the collateral for ETH call option is ETH and for ETH put option it is USDC. We use USDC as our put option collateral because it keeps it’s peg the most and is more trustworthy than other stablecoins.
ERC20 or NFT
If the option can be transferred and be sold in the secondary market, it is considered to be transferable. Transferable options are better because then there will be a liquid secondary market for the options and would result in more liquidity.
Most of the option protocols tokenize the option and make it transferable. Options are tokenized as an ERC20 token or an NFT. Every option protocol besides Hegic has options as an ERC20 token.
Options that are tokenized as ERC20 are easier and simpler to trade on secondary markets, since most DeFi platforms support ERC20 but not NFTs.
Our protocol tokenize options as an ERC20 token and you can trade Lien options in the secondary market with the app below.
There are 2 ways to provide liquidity for options, order books or pools. Order books is the type most traders are familiar with on centralized exchanges like Binance.
Traders submit buy or sell orders at prices that they want to trade. If someone else wants to trade at those prices, the trade is executed. It is easy to provide liquidity on order book types and we expect more traders to participate in the future.
Another type is providing liquidity through pools, where traders put in capital in pools and traders who want to buy options trade against the pool. It is easy for smaller traders to provide liquidity in pool types because they can share in the risk and return of providing liquidity of options without managing the risk. The size of the pools will determine the trading volume of options in pools. Hegic is an example of a pool type option protocol.
Lien holds an inventory of options with oracle pricing to price the options and then sell the options to traders. The options are now priced with an improved volatility oracle and allows us to price the options more accurately and leads to fair prices for traders.
Also, after the launch of v2 on Lien, traders will be able to provide liquidity through a pool, and will be able to capture returns generated from selling options. By providing liquidity through pools, traders with smaller capital will also be able to participate in selling options and getting premiums.The options will be priced using our improved volatility oracle, so traders will get premiums that reflect market conditions.
To issue an option you need to put up collateral, most option protocols require you to put up 100% of the collateral, including the Lien protocol.
This is because options sellers have to be able to meet payoff at all times and that requires 100% collateral. Option protocols in DeFi are less efficient in terms of capital requirements compared to traditional finance due to trustless-ness.
With the Lien protocol, you can create exotic options such as butterfly options, which is more collateral efficient than just issuing plain vanilla options.
This is the current state of option protocols. Since the DeFi industry moves fast, this may change in a few month’s time. Each platform is different in what they value and it is exciting to see how each of the option protocols evolve over time.
The strength of Lien Protocol is that it enables traders to trade options at a price close to fair value as a result of the volatility oracle. This will lead to a more liquid secondary market. V2 will allow traders to sell options and gain premiums, which will attract more traders to Lien.
Keep an eye on option platforms and happy trading!