The Decentralized Finance (DeFi) ecosystem has benefitted from significant innovation during the last two years. Among other factors, the development of secure DeFi options protocols such as Opyn is contributing to this innovation, attracting significant capital inflows and trading volumes.
This guide will cover DeFi option basics. We’ll explore what they are, how they work, why traders use them, and identify the primary risks a user must consider before taking an options position in DeFi. We will then shift the focus to Opyn, and provide resources that illustrate how the gamma protocol enables users to trade DeFi options on Ethereum and ERC20s.
Table of Contents
What Are DeFi Options?
Options are derivatives contracts that give the buyer the right, but not the obligation, to either buy or sell a fixed amount of an underlying asset at a fixed price on a certain date (for European options). In DeFi, underlying assets can include any ERC-20 assets, such as: WETH, WBTC, UNI, YFI, SNX, among others.
People use options for a variety of reasons. The primary reasons include: income generation, speculation, and hedging. Given the volatile nature of cryptocurrencies, the most popular example of using options is to hedge against declining asset prices to limit downside losses. Options are also used to generate recurring income. Additionally, options can be used for speculative purposes, allowing traders to use leverage to make a directional bet on the price of an underlying asset.
The primary distinction between options and other derivative contracts (forwards, futures, etc.) is that in an options trade, the holder has the right, but not the obligation to exercise their contract. If an option is out of the money, the option buyer simply lets the option contract expire, recognizing the loss of the premium paid to purchase the contract. On the other side of the transaction, option sellers earn this premium and realize a profit.
Key Option Terms:
- Option: Options are financial instruments that are derivatives based on the value of underlying assets such as ETH or BTC. An options contract offers the buyer the opportunity to buy (calls) or sell (puts) the underlying asset.
- European Settlement: An options contract that can only be exercised at expiration. Exercising a call or put option will only take place on the date of the option’s expiration.
- American Settlement: An options contract that allows holders to exercise the option at any time before, and including, the day of expiration.
- Physical Settlement: Physically settled options are options contracts whereby settlement requires the actual physical delivery of the underlying asset. For example, a put option holder will “put” ETH to the options seller at the option’s strike price, even if ETH is worth 0.
- Cash Settlement: A cash-settled option is a type of option whereby settlement results in a cash payment, instead of settling in the underlying asset. The cash payment is equal to the option’s intrinsic value at the time it’s exercised.
- Call Option: A call option is a financial contract that gives the option buyer the right, but not the obligation, to buy an asset at a specified price for a specific amount of time.
- Put Option: A put option is a financial contract that gives the option buyer the right, but not the obligation, to sell an asset at a specified price for a specific amount of time.
- Option Buyer: The person who buys an option by paying a premium. This person has the right, but not the obligation, to exercise the option. Also known as an options “holder,” or someone who is “long” an option.
- Option Seller: The person who sells an option in return for a premium. The option seller is obligated to perform when the buyer exercises their right under the option contract.
- Collateral: Collateral refers to an asset given as security by the options seller in order to hedge the credit risk of the options transaction.
- Underlying: The underlying asset on which an option’s value is based. It is the primary component of how an option gets its value. Options are classed as derivatives because they derive their value from the performance or price action of an underlying asset.
- Premium: The money paid upfront by the option buyers to the option sellers in return. It is the cost of the option.
- Bid: The price a buyer is willing to pay for the option. If you’re selling an option, this is the premium you’d receive for the contract.
- Ask: The price a seller is willing to accept for the option. If you want to buy an option, this is the premium you’d pay.
- Strike Price: A strike price is the set price at which an options contract can be bought or sold when it is exercised. For call options, the strike price is the price an asset can be bought; for put options, the strike price is the price at which the asset can be sold.
- Expiration date: The date when the options contract becomes void. For European options, it’s the due date for options buyers to exercise the options contract. For American options, it’s the date by which options buyers must exercise the options contract.
- Exercise: To exercise means to put into effect the right to buy or sell the underlying asset at the strike price. If the holder of a put option exercises, they will sell the underlying asset. If the holder of a call option exercises, they will buy the underlying asset.
- At The Money (ATM): A call or put option is at-the-money when its strike price is the same as the current underlying asset price.
- In The Money (ITM): Refers to an option that possesses intrinsic value. A call contract is in the money when its strike price is less than the current underlying asset price. A put contract is in the money when its strike price is greater than the current underlying asset price.
- Out of The Money (OTM): An option that only contains extrinsic value. A call option is out of the money when its strike price is greater than the current underlying asset price. A put option is out of the-money when its strike price is less than the current underlying asset price
- Time value: The value of an option based on the amount of time before the contract expires
- Intrinsic value: The in the money portion (if any) of a call or put contract’s current market price. Intrinsic value is a measure of what an option is worth
- Volume: The number of contracts traded that day
- Open interest: The number of options contracts currently in play.
Typical options syntax is: Asset Name — Expiration Date — Strike Price — Option Type, e.g. ETH Dec 15 500 Call
How Options Work
Options are derivatives, which means their price is derived from the price of an underlying, distinct asset. DeFi options are simply those in which this underlying asset is an on-chain asset, such as: WETH, WBTC, UNI, YFI, SNX, among others. Aside from certain specific risks which we’ll discuss later, the primary factors that determine DeFi option pricing are analogous to those in the regular options market, namely: current asset price, strike price, time to expiration (also known as time value), and volatility. It’s important to note that the correlation between movements in underlying asset price and the option price is not 1:1, and varies over the life of the contract. Examples of DeFi options include calls, puts, and spreads, among others.
Reasons to Use Options
As previously mentioned, traders use options to generate income, to take speculative positions, to use leverage, and to hedge risk.
Selling options can generate income from options premiums with the hope the option expires worthless. Two strategies that are widely used are selling calls against assets you own (known as a covered call), and selling puts against assets you want to buy at a certain price (for physically-settled options).
- A call option is out of the money when the underlying asset price is below the strike price. In this case, the options writer (seller) keeps the premium as profit.
- A put option is out of the money when the underlying asset price is above the strike price. In this case, the options writer (seller) keeps the premium as profit.
A speculative options strategy allows a person to bet on the future price direction of an asset. A common reason for traders to use this approach is that the person does not want to tie up a significant percentage of their capital in an underlying asset (buying the asset outright), yet still wants to make a directional bet on the asset price. If the option closes in the money, the option holder earns a profit on their speculative bet. For this reason, options provide leverage to potential holders.
- An in the money call option gives the option holder the right to buy the asset below its current market price. In the money indicates that the strike price for the call option is below the current market price
- An in the money put option gives the option holder the right to sell the asset above its current market price. In the money indicates that the strike price for the put option is above the current market price
Another primary reason for options trading is to reduce and hedge risk. Hedging with options allows traders to reduce risk at a reasonable cost. In this context, think of an option as an insurance policy that limits your downside risk. Put options can be used to insure your investments against a downturn. To buy this insurance, the options buyer needs to pay some amount of premium upfront. In exchange for this premium, the options buyer limits their downside risk and enjoys all the upside in a cost-effective way.
Buying and Selling Options
People who buy options are called holders and people who sell options are called writers. Buying an option is considered going “long” an option while selling an option is considered going “short.” There are important distinctions between holders and writers of options:
- Call holders and put holders (option buyers) are not obligated to buy or sell the underlying asset. They can decide whether or not to exercise their options. This limits the risk of buyers to just the premium spent on the option.
- Call writers and put writers (sellers) are obligated to buy (in the case of a put) or sell (in the case of a call) if the option expires in the money. This implies that option sellers have exposure to more risk. If the option seller does not hold the underlying asset, writers can lose much more than the price of the options premium. A key distinction to remember is that the underlying risk to a call writer is theoretically unlimited. Conversely, a put writer’s maximum risk is the strike price, since the maximum loss of a put is the strike price minus zero.
Call and Put Options Basics
For simplicity, let’s look at the basics of buying and selling calls and puts. Remember, call options give the holder the right to buy an asset at a set price, and put options give the holder the right to sell an asset at a set price.
Call Option Basics
With call options, the strike price represents the predetermined price at which a call buyer can buy the underlying asset. For example, the buyer of an ETH call option with a strike price of $100 can use the option to buy ETH at $100.
The call buyer has the right to buy ETH at the strike price on the expiration date for European options. For that right, the call buyer pays a premium. If the price of ETH moves above the strike price ($100), the option will be in the money (it will have intrinsic value). The buyer can either sell the option for a profit prior to expiry or exercise the option at expiry in order to receive ETH from the option seller.
In exchange for selling the call option, the call writer receives the premium (the option’s price). Writing call options allows sellers to generate income. It’s important to note that the income from writing a call option is limited to the premium, while a call buyer theoretically has unlimited profit potential.
Put Option Basics
With put options, the strike price represents the predetermined price at which a put buyer can sell the underlying asset. For example, the buyer of an ETH put option with a strike price of $200 can use the option to sell ETH at $200.
The put buyer has the right to sell ETH at the strike price at expiry for European options. For that right, the put buyer pays a premium. If the price of ETH moves below the strike price ($200), the option will be in the money (it will have intrinsic value). The buyer can either sell the option for a profit prior to expiry or exercise the option on the expiration date in order to sell ETH to the option writer (the seller).
In exchange for selling the put option, the put writer receives the premium (the option’s price). Writing put options allows sellers to generate income. It’s important to note that the income from writing a put option is limited to the premium, while a put buyer can maximize profit until the asset, in our case ETH, goes to zero.
Greeks / Options Risks / DeFi Risk
Using the “Greeks” to Understand Options
The Greeks are industry standard nomenclature to define the underlying risks associated with taking an options position The convention provides a way to measure the sensitivity of an option’s price to various quantifiable factors. The five most common ‘Greeks’ that traders use are Delta, Gamma, Vega, Theta, and Rho.
Delta (Δ): Sensitivity of an option’s price to the underlying asset price
- Delta explains how an option will react if the price of the underlying asset goes up. For example, a long call on WETH is a bet that WETH will go up. The Delta tells us how strong this relationship is, quantitatively. I.e. a .5 delta means a call goes up $.50 for every $1 increase in WETH.
Gamma (Γ): Sensitivity of delta to the underlying asset price
- Gamma explains convexity, or the slope of delta. It is the derivative of delta, expressing how delta changes as the price of the underlying goes up.
Theta (Θ): Sensitivity of an option’s price as time passes
- Theta tells us how an option’s price changes as time goes by. All options eventually expire. As they approach expiry, they become less useful & decrease in value. Theta tells us how quickly this decline takes place. I.e. a -.5 theta means an option goes down $.50 every day.
Vega (V): Sensitivity of an option’s price to implied volatility
- Vega explains how an option’s price changes as (implied) volatility of the underlying asset changes. All options go up in value when the market predicts increased future volatility.
Rho (ρ): Sensitivity of an option’s price to interest rates
- Rho expresses the relationship between interest rates and an option’s price. If negative, that means an option will go down in value if interest rates go up. If it is positive, then an option’s value will go up with interest rates.
It’s important to note the numbers given for each of the Greeks are strictly theoretical. The values are projected based on mathematical models, however a general understanding of these concepts is fundamental for any options trader looking to manage their risk.
For more information about Greeks, read this.
Options, like all other assets, have their own underlying risk.
While hedging with options may help manage risk, it’s important to note that all investments carry some form of risk. For people who purchase options, loss is limited to the price paid for the premium. Since writers of options are sometimes forced into buying or selling an asset at an unfavorable price (ETH), the risk associated with selling options may be higher. In some cases, call writers can be exposed to unlimited risks (in the case of selling uncovered calls).
Risks associated with earning premiums by selling options:
- Put Options: If the option buyer exercises, you could lose some or all of your collateral.
- Call Options: If the option buyer exercises, you could lose some or all of your collateral. However you would receive the option premium in return. (e.g. buyer’s USDC)
In addition to financial risks, investing in DeFi requires an understanding of cryptocurrencies and the security risk of smart contracts. For this reason, DeFi is considered a high-risk opportunity. Below are risks specific to DeFi products:
Smart Contract Risk
- Smart contract vulnerabilities remain a serious issue. Hackers can still exploit vulnerabilities in smart contracts. Despite improved audit procedures, bugs can still be missed, and it’s up to users to do their own research to decide if they’re comfortable with the underlying contract.
- Beyond the software risk created by the developers of DeFi products, people who use cryptocurrency take on procedural risk associated with their use of apps and private keys that might put their assets at risk. Using certain wallets or maintaining weak authentication methods can put user holdings at risk.
Governance Vulnerabilities and Changes
- Updated protocols, admin key compromises, and frequently changing terms of service agreements among various DeFi protocols, digital wallets, and exchanges are additional risks DeFi enthusiasts must be aware of. Maintaining a pulse on these types of governance changes will be critical for investors who decide to use DeFi products.
- Investors of traditional financial products have access to historical data and benchmarks to evaluate investment opportunities. Despite DeFi experiencing an incredible surge over the last few years, the lack of extensive historical data or benchmarks makes it difficult to evaluate the risk of investments in traditional terms. DeFi investors must operate within a certain environment of ambiguity, which offers both risks and opportunities.
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