Underneath the hood (Part 2)
Hello Oilers!
In this series of article, we talk about everything Oiler is built upon. Our first article was a back to basics focused on the ethos of options. We invite you to read it for the first time or re-read it again: Oiler’s back to basics.
In case you might want a refresher on what we’re building, don’t hesitate to do so and read our previous articles:
In this article, we will dive deeper into understanding options and the different types of options available.
There are two different types of options: Americans and Europeans.
Guess what’s the difference?
You’re god damn right, a healthy dose of freedom is what separates American and European options. To be fairly honest, it actually refers to the fact that Europe was very bureaucratic back when options were created. American options can be exercised at any time before their expiration while European options can only be exercised when they expire.
As proud people of DeFi, we are pro-freedom. This is why we chose American options. One thing people need to know about American options is that they are more expensive. Freedom obviously comes at a cost.
Traditional options are contracts which give its holder either the choice or the right to buy or sell the underlying asset at a price before or on the expiration date. Exercising the option converts the contract to shares at the strike price.
There are, as one could imagine, many types of options. Exotic options are contracts differing from this traditional definition, they can be fully customized to meet the desires of the investors. Most of these options trade in the OTC market. We have yet to see more of them in DeFi.
In Oiler’s case, we started with binary options.
Binary options are options in which transactions are assigned to one of two outcomes possible. These two possible outcomes are when the option is in the money (ITM) or out of the money (OTM). It’s a zero-sum game for the traders and some pleasant fee collection for the providers of the instruments 🛢️
Binary options provide a way to trade markets with capped risk and capped profit potential, based on a yes or no proposition.
Let us go back to our profit fuelled ape’s story from our first article to make things clear.
Our alpha leader placed a call option on the price of bananas, expecting them to be more expensive during the winter. His call option will be ITM when he has the ability to buy the bananas below its current market price.
In our case, remember that the alpha leader had to pay a premium to enter his position, which means that before being ITM, the market’s price has to be above what he paid.
Our beta leader, on the contrary, placed a put option on the price of bananas, expecting them to be cheaper during the summer.
His put option will be ITM when he has the ability to sell the bananas above its current market price. Again, our beta leader had to pay a premium, which means that before being ITM, the market’s price has to be below what he paid.
When an option is not ITM, it is by definition OTM. If your contracts are not ITM at expiry, well,… HFSP. Very obviously your funds just went to 0.
It is, as we express clearly, an all-or-nothing game, or a binary outcome to sound smarter.
At Oiler, we invite our users to trade using American Binary Options. Hopefully, now you understand what this means! 🛢️
In case you still don’t, here’s what this means in plain English: You can decide, before the expiration date of your contract to exercise your option when you are ITM and, therefore, make money. You can also exercise it OTM and, therefore, lose money.
Absolutely lovely one might say.
Especially if you’re on the winning side of the trade.
Let’s go deeper now.
How are binary options calculated? Their price is determined by the market, aka the traders clicking on the bid and ask.
How does one build an option? What is underneath the hood of an option?
How does one calculate the price of an option?
Options are often calculated based on what is called the Black Scholes model or Black Scholes-Merton (BSM) model. Merton and Scholes actually received a Nobel in 1997 for their work! Fun (dark-humour) fact, Nobels are not attributed to the dead so Fischer Black never received his but his work was acknowledged in this discovery.
BSM are one of the most used models for option pricing, unfortunately, they work on European options so it’s not for us, but I had to give it a nudge just for its impact on the Options market. Especially because they could be calculated in DeFi using ZK-Rollup I heard. Could be just a rumour, who knows?
A very famous model used for option pricing is the Monte Carlo Simulation. This simulation has multiple applications as it results in a range of net present values of the investment analysed and its volatility.
In option pricing, we use Monte Carlo to build random paths for the price associated with a payoff which are then discounted to the present and averaged to give out the option price.
Liquidity providers should be able to define the American binary options pricing models for the instruments available on Oiler. We invite you to look at one of our sources of inspiration.
These calculations take into account the following parameters:
- Price: The initial value of the asset being traded
- Strike price: The set price at which a derivative contract can be bought or sold when it is exercised. It’s also known as the exercise price for this reason.
- Rate: The risk-free interest rate
- Time: Time in an option contract decays. This means that the value of the option contract loses value over time. Time decay measures the rate of decline in the value of an option’s contract over time.
- Volatility: How much an option’s premium fluctuates.
- Yield: Refers to the earnings generated and realised over a period of time.
- Direction: Call or put
Currently, like most options trading platform in DeFi (if not all), our pricing mechanism is not perfect, because they can’t happen on-chain and off-chain solutions are yet to be implemented.
We currently have different pricing models in our pipeline. One of them would be based on EIP-2935, an important EIP in which Tomasz is involved.
Now that we had the time to explore a bit about options, next-up should be the factors to measure risk. An option’s price is influenced by various factors, also known as, the Greeks…
There exist four primary Greek risk measures:
- Theta: references the rate of decline in the value of an option due to the passage of time. An option loses value as time moves closer to maturity. There are evidently fewer chances to see an option expire in the money (pass the strike price) if there is less time until its expiry.
- Vega: references an option’s price sensitivity to changes in the volatility of the underlying asset. It represents the amount an option contract’s price changes in reaction a 1% change in the implied volatility of the underlying asset. Vega, as it is based on volatility changes when there are large price swings in the underlying asset. If the vega of an option is bigger than the bid-ask spread, the option is said to offer competitive spread. The opposite is also true.
- Delta: references the ratio representing the change in the price of an asset to the corresponding change in the price of its derivative. Delta values are positive or negative depending on the type of the option (calls are positive while puts are negative). It is commonly used to determine the likelihood of an option expiring in the money.
- Gamma: references the rate of change in an option’s delta per 1 point movement in the underlying security. The larger the gamma is, the more volatile the price of the option is. Options at or near the money have high gamma while options far in the money or out of the money have low gamma because demand reacts accordingly to the price of the option.
The following table should enable anyone to understand what’s up.
There also exist plenty of minor Greeks such as:
- Lambda: references the ratio of how much leverage an option is providing as the price of that option changes. It is referred to as the leverage factor.
- Vomma: references the rate at which the vega of an option reacts to volatility in the market. It is a second-order Greek, its value provides inside on a first-order Greek (Vega) and its changes with an implied volatility of the instrument.
- Ultima: references the rate at which Vomma reacts to volatility in the underlying asset. It is known as a third-order Greek.
Bottom line, the Greeks provide interesting numbers on an option’s risk and potential rewards.
At this point, you’re meant to understand how options work. Or at least have a general understanding of the concepts behind them.
In our next post, we will focus on the underlying instruments you can trade on Oiler.
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
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