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What are binary options and why should you care?

We are excited to announce yet another release: Weekly binary options on Compound’s $COMP token!

Binary options are easy to understand and trade, thus making it a good financial product for users who like to speculate on the future value of an asset in a very simple manner.

In this article we will explain what binary options are, why they are useful and how to start trading them!

What are options?

Let’s start with the basics. Just like other financial “derivatives”, options are financial products that provide exposure to future price movements of an underlying asset without actually owning the asset itself.

It works like this: An options contract offers the buyer the opportunity to either buy or sell — depending on the type of contract they hold — the underlying asset at a certain price. Options can therefore be used to speculate on both price drops and price increases whilst requiring less capital. This also makes it an excellent option (pun intended) for hedging risk while trading on the spot market, which means buying or selling actual crypto.

What are binary options?

In traditional finance, there are a lot of option types available. Some examples are vanilla options which are physically settled (ie. forces you to actually buy or sell the underlying asset) and cash-settled options with fixed initial margin (ie. potential payout in cash is known upfront). The payoff of these options are depending on the actual price of the underlying asset at expiry of the option. The higher or lower the actual price, the higher or lower the payoff for the trade counterparty that was right.

Binary options are different because of their steep payoff function. A binary option trader either wins the full margin locked in the option contract or loses it. Winner-take-all. There is no in between.

When binary options can be useful

As mentioned before; binary options are very easy to understand. It enables “betting” on a fixed price prediction of the underlying asset. On Opium, we just released two binary options for the $COMP token:

  1. $COMP Binary Call Option @ 250 DAI: Buy this if you believe the price of $COMP will be above 250 DAI at the expiry date. Sell if you believe it will be lower.
  2. $COMP Binary Put Option @ 150 DAI: Buy this if you believe the price of $COMP will be below 150 DAI at the expiry date. Sell if you believe it will be higher.

Professional traders sometimes refer to binary options trading as “gambling” because the payoffs are either very high or very low, but binary options can actually be a very powerful instrument in DeFi! As we have seen, volatility can be high and valuations can be extremely irrational — especially directly after trading of a new token has started. Binary options are a simple way of expressing strong optimism or pessimism on the value of a DeFi token.

How do binary options work?

Before we explain how to trade binary options, let’s first build some basic knowledge on how they work in the first place. For this explanation we will use the $COMP Binary Put Option @ 150 DAI as a reference.

A binary option contract always have a buyer and a seller. The seller locks some margin (in this case: DAI) in the options contract and the buyer then purchases the contract by paying the seller directly. The option contract is then settled on the Ethereum blockchain and the margin is locked until expiry. At expiry of the options contract, the current price of $COMP will determine the payoff of the initially locked margin.

As explained before, binary contracts have a very steep payoff curve which makes for a winner-take-all situation as visualized in the graph below.

Example payoff chart for a binary options contract. Horizontal axis shows the price of $COMP at expiry, vertical axis shows the payoff in DAI.

How to trade binary options?

Binary options have existed for a long time in traditional finance, but were recently introduced and made big in DeFi by Synthetix. Although they provide a pleasant user experience, unfortunately they have not added binary options for Compound’s $COMP token.

Let’s look at a step-by-step approach of trading the recently launced $COMP binary options on Opium.Exchange, once again taking $COMP Binary Put Option @ 150 DAI as a reference. Since every option contract has a buyer and a seller, we will consider the option buyer as a reference in this example.

Step 1: Order creation

Go to Opium Exchange and select the OEX-BPUT-COMP-3JUL-150/50 ticker from the left sidebar to place an order. Specify the price you are willing to pay for this option contract and also specify the quantity you would like to buy.

Step 2: Settlement of options contract on Ethereum

Once your order has been created, it can be cancelled anytime until it is matched with a counterparty. Once matched, the options contract is settled on the blockchain and the margin paid by both the buyer and seller are locked until expiry.

Step 3: Option contract expiry (handled by Opium Exchange)

At expiry of the option contract, the $COMP price is used to determine the payoff. Let’s consider two scenario’s:

  • The price of $COMP is higher than 150 DAI: As buyer of this option contract, you were wrong and lose the price you paid for the contract.
  • The price of $COMP is lower than 150 DAI (or exactly 150 DAI): As buyer of this option contract, you were right and will all the DAI that the option contract seller put up as margin.

Closing thoughts

Binary options can be an effective and easy way of expressing bullishness or bearishness regarding the price of an asset, which can be tremendously useful and lucrative in this early DeFi space. Do however note that the payoff is very steep and therefore only trade binary options when you are feeling certain of a particular scenario.

About Opium

The Opium protocol is a universal protocol to create, settle, and trade virtually all financial derivatives on top of Ethereum’s trustless infrastructure. We also created the Opium Exchange, where we list useful derivatives to long and short popular DeFi tokens, as well as hedge trading risks.

Based on feedback of our beloved users, we are planning on releasing a brand new interface for Opium Exchange that makes it easier to find, select, and trade financial derivatives built on our open protocol. Stay informed by following Opium.Team on Twitter or join our Telegram community!

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Opium Protocol is the universal protocol to create, settle and trade virtually all derivatives in a trustless way.

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Deniz

Crypto native, in deep since '17. Passionate about coordination mechanisms and Decentralized Finance. Product Manager @ MakerDAO. wagmi culture.