Oiler’s back to basics (Part 1)
Hello Oilers!
Remember us?
If you don’t and want to get to know us better, don’t hesitate to do so and read our previous articles:
If you’re in a hurry and want to learn more about what we are building, here is our elevator pitch:
“Oiler is a protocol for blockchain native derivatives enabling its users to hedge their risks against volatility and protocol risks”.
In this series of articles, we intend to share with you some insights regarding what we are building. Before using Oiler, one needs to understand its underlying. Which is why we prepared this back to basics series.
In this series, we will deconstruct the underlying concepts linked to Oiler.
Today, we will start with the product Oiler is relying on: Options.
Options
Options trading has been hyped recently in DeFi because options trading is one of the key components of most trading strategies and their arrival in DeFi was long-awaited. Options can be used mostly for two purposes: to speculate and to hedge their risks.
When options were introduced to DeFi, the market mostly started to use them to profit from the market and speculate. Speculators love options because once they expect the price of an underlying to move based on their analysis, they can use options to create limited risk strategies and profit from the leverage the option gives them.
This is not only seen in DeFi, but we’ve also been able to witness such kind of behaviour happen on the stock market. The degens of Wall Street Bets are known to be the equivalent of the DeFi apes. It is not highlighted enough that this kind of speculation is better than most derivative trading as the risk is limited when the options are used correctly.
To be honest, options were actually invented for hedging purposes and not to speculate. We’re just flawed greedy beings taking advantage of everything great humanity has to offer. Options contracts are closer to insurance product in their core characteristics than leveraged trading instruments.
By using put options, one can limit its losses and by buying call options on a market which might increase in value and that you haven’t yet bought in, you hedge your opportunity cost of moving more funds on the other trade.
Options are less riskier than margin trading, especially in DeFi. Simply because you are protected against squeezes.
A squeeze is when an asset price moves extremely fast and often results in hitting your stops forcing you to market buy/sell which adds to the pressure and causes prices to move of a larger delta etc. With an option, you will not be stopped out of your position, you can wait for the squeeze comfortably to pass.
There is an option scenario appropriate for every market participant. We will present the case for every market participant in the DeFi market in a dedicated article very soon, hence, make sure you follow to stay up to date.
What are options?
Options are contracts that give the bearer the right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expires (Investopedia).
Options are derivative instruments. Derivatives are instruments with a value derived from an underlying benchmark. The derivative itself is a contract between several parties which derives its price from fluctuation in the underlying asset.
Why options are great, from one ape to another
Our very own Tomasz explained to us, apes, options using bananas as underlying for the sake of simplification.
Let us go back in time and pretend it is late summer again. The first bananas are ripe and ready to be harvested (banana season, how to harvest and store them, an in-depth article for the most educated apes).
Bananas are flooding the market and their price is only $3 per kilo.
The alpha tribe is well fed but knows that winter is coming. When winter comes, the price of bananas will obviously go up because feast after feast we will gradually lower the supplies of bananas we own.
To protect our tribe, our alpha leader contacts the closest banana broker and proposes to write a contract enabling him to buy bananas in the middle of the winter. The banana broker agrees to write this contract.
Because the banana broker might be able to sell the bananas at a higher price in the middle of winter, he decides to set a strike price of $5 with our alpha leader. This price is above the current market price of $3, but our alpha leader knows that banana prices during the winter season can rise higher than $5.
The alpha leader wants to protect its tribe, therefore, he agrees to sign this contract and to pay a premium to protect our alpha tribe. Let us think of this act as a down payment for a future purchase.
Our alpha leader is smart. He knows that he can accumulate enough bananas for the tribe with our funds to survive for the summer and part of the winter. But if the price of bananas increases too much, we won’t have enough to survive.
Our alpha leader, therefore, holds on for our tribe’s life to this contract during autumn and the beginning of winter. Now that the time has come, most bananas are getting rotten and good bananas are getting rarer and more expensive, their price reached $10 per kilo. We can’t afford them no more.
Our alpha leader decides to make a move and calls his banana broker to exercise his right to buy bananas at $5. The broker agrees and the contract is resolved.
We are flooded in bananas, we feast and return to our cosy caves, knowing that winter will be good, thanks to an educated ape.
Let us now take the scenario of the beta leader which unfortunately feasted so much that he forgot to call his broker and is stuck in the middle of the winter buying $10 bananas.
This beta leader is not sure whether or not his tribe will be able to feast during the summer if they have to spend too much during the winter. He comes up with a plan and decides to talk to his banana broker. He wants to ensure that his tribe will be able to feast the whole summer. Fat, they must accumulate, to be strong for the next winter.
Our beta leader, therefore, decides to buy the option to put his bananas on the market at $10. His banana broker agrees and they write a contract which will last until the end of summer.
Our alpha leader knows that even though he is paying a premium at the moment, the banana season will come back and once the market is flooded with great bananas, their price will tumble. This option will act as an insurance policy to protect their summer feast.
Time passes and now that summer has come, bananas are harvested. Our beta leader decides to call his banana broker and profit from the price difference, therefore, ensuring a great summer for his tribe.
Both our leaders profited from the market because of their knowledge of the banana activity. Feasts are protected. The tribe is safu. All is good.
Now, in traditional terms
In this lovely example, we highlighted why our apes were able to take advantage of the market while others were struggling.
Our leaders decided to buy options deriving from bananas price. Their counterparty WROTE a contract with them and set a STRIKE PRICE of $5, trading at a PREMIUM and set an EXPIRATION DATE for the middle of winter.
Important terms:
Call options give the right to buy the underlying while a put option gives its holder the right to sell them.
What we didn’t talk about is that we have the right to buy and sell calls and puts. The person buying an option is called a holder. The person selling an option is called a writer. There are substantial differences between a holder and a writer:
- The holder is not obligated to buy or sell the underlying, they have the right to exercise their rights. Which means that their risk is limited to the premium spent. They can’t lose more than what they decided to invest in the option.
- The writer, on the other hand, is obligated to buy or sell the underlying if the option expires in-the-money. The seller will be obligated to respect their contract, which implies that their risk could be unlimited.
What happened with the oil prices on April 20 is a great example of the dangers of writing options and futures markets.
For those who don’t remember what happened, the price of oil turned negative for the first time in history. Oil producers were paying buyers to take the commodity of their hands. This price went as high as -$37.63 a barrel of US oil.
Why? Well, because traders had to offload their holdings to avoid the risk of taking delivery of the oil and paying for storage costs. This case is regarding future markets, not binary options directly but they highlight that things can turn sour very fast for writers.
Fun fact, using the widespread Black-Scholes option pricing model became a problem when the underlying became negative (Black-Scholes imply that the pricing remains strictly positive), which caused serious challenges for pricing and risk management activities like delta-hedging.
Hopefully, we can’t have negative gas prices on Ethereum. Only two operations cost negative gas such as STORAGEKILL (-15000) and SELFDESTRUCT (-24000).
This is why we want to emphasize that risk of writing an option is unlimited.
Now that we understand what Options are, let us look into how they work and most importantly, what kind of Options exist in our next article. Stay tuned!
Legal Notice:
This article and any information contained in it is subject to the Oiler Legal Notice available at https://docs.oiler.network/oiler-network/token/legal-notice-and-risk-disclosure-statement. Please carefully review the Legal Notice as it contains important legal information, risk disclosure statement, limitations and restrictions relating to the information that we provide, third-party resources and forward-looking statements.
Links
Oiler’s Website: oiler.network
Oiler GitBook: https://docs.oiler.network/oiler-network/
Oiler’s Medium: https://medium.com/oiler-network
Oiler’s Twitter: https://twitter.com/OilerNetwork
Oiler’s Discord: https://discord.gg/bxMsvVTgJp
Oiler’s Telegram: https://t.me/oilernetwork
