What are call options and How do they work?
To fellow crypto enthusiasts and Lien Protocol users,
In this series, we are going to walk you through how Lien Protocol works while touching upon its basic components as well as some of the relevant concepts that help explain the mechanisms of these components.
In this article, we are going to explain what call options are and how they work.
It’s important to have a basic understanding of call options as it helps you better understand one of the basic building blocks of the protocol, Liquid Bond Token (LBT), which essentially functions as a call option on ETH.
Alice, Bob, and Coffee
A call option is a type of derivative product that allows for hedging a risk involved in financial transactions by giving the buyer of the contract the right to buy a particular asset at, or prior to, some point in the future at a pre-specified price.
Let’s look at a simple example so the above paragraph makes more sense within the context of our discussion.
Let’s say Alice is a coffee shop owner and is buying coffee beans from Bob, a coffee farmer, because she loves the specialty coffee produced by Bob’s farm.
She has a full stock of coffee beans that she’d bought from Bob 2 weeks ago and she is now planning on making an additional purchase 3 months from now as she estimates the stock to last for the next 3–4 months given the amount of coffee she sells every day.
What she doesn’t know, however, is the price at which the coffee will be sold 3 months from now — since she is buying coffee beans directly from Bob, rather than at Starbucks or McDonald’s that have the ability to offer more stable prices. The price at which she can buy coffee from Bob can fluctuate a lot more based on numerous factors (e.g. supply chain disruption caused by the coronavirus), which could cause an issue from Alice’s standpoint.
For example, if the price of beans has gone up to the point where Bob has to raise the price he offers Alice so he can remain profitable, that could directly hurt Alice’s profit margin because she has to pay more to supply the coffee beans she needs, potentially causing her to increase the price of coffee she sells at her shop.
Call Option in Action
Here, wouldn’t it be nice if she was allowed to buy beans at a specified price (e.g. $10 per each bag) regardless of what happens to their actual price in the future?
Essentially, this is what a call option allows her to do — it gives her the right, or the “option”, to buy a commodity (e.g. coffee beans, corns, etc.) or financial asset (e.g. stocks, cryptocurrency, etc.) at a pre-specified price on a future date.
Note that, when the transaction involves buying an asset at some point in the future, we call the option a “call option” as described above, whereas if the asset is sold at that point, the option is called a “put option”.
In this example, since she needs to buy coffee beans from Bob, she will take advantage of a call option, with the beans serving as the “underlying asset” of this contract
Now, if the price of beans soars to $11, she can still buy them at $10. Conversely, if the price goes down below $10, she doesn’t have to pay a premium and buy them at $10 — she can simply pay whatever price is offered by Bob, which is probably $10 or less. She can even decide not to buy the beans at all if she so chooses.
Using a slightly more formal language, we could define this arrangement as having coffee beans as its “underlying asset” and the “strike price” of $10, with the “expiration/maturity date” set to 3 months into the future.
Here, she does have to pay for the privilege of being able to choose between buying or not buying the coffee at a certain point in the future with the pre-specified price while taking into account its actual future price after the fact. If she were allowed to freely take advantage of this arrangement, she would always make a profit as she will have 100% certainty regarding the price. From Bob’s perspective, he will lose out on every transaction he conducts with Alice and there will be no incentive for Bob to enter into this contract in the first place.
Obviously, the above is a contrived example and, in practice, you wouldn’t see a coffee merchant and coffee producer conducting options transactions in a way described above — for example, the buyer is usually a large, global company (e.g. Nestlé) that requires huge delivery of coffee beans or a speculator with significant capital that is trying to profit from the price fluctuations in coffee beans, rather than a small, family-owned business such as Alice’s — but hopefully you now have a high-level understanding of what call options are and how they work.
What is innovative about Lien Protocol is that it allows everyday users of ETH to create options out of ETH.
In the next article, we are going to look at how LBT serves as an ETH call option (i.e. call option using ETH as its underlying asset) and how it can provide you with a unique way of speculating on — and profiting from — the price development of ETH while simultaneously allowing risk-averse investors to hedge their risks through the issuance of a stable coin.