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Opyn Partial Collateralization: How to Trade Partially Collateralized DeFi Options

tl;dr

  • Opyn is launching the first-ever on-chain margining system for partially collateralized options
  • The upgrade allows options to be collateralized with less than their max loss (<1 asset for call, <strike for puts), increasing capital efficiency and providing leverage for DeFi options
  • Margin requirements are based on the strike price, spot price, a shock to spot parameter, a conservative assumption on vol/premium, and time to expiry
  • Sellers will be required to maintain a minimum amount of collateral in their vault to secure the options they have sold

Table of Contents:

Background

Opyn Partial Collateralization Overview

Margin Design

Liquidation Mechanism

Opyn Partial Collateralization Tutorial

Appendix

Background

To date, one of the biggest limitations of options in decentralized finance was that users were required to fully collateralize options trades. In traditional finance, margin required for options only represents a small fraction of the total value of the contract, making options a highly leveraged trading vehicle. Trading on margin is also why traditional financial markets have been more capital efficient than DeFi but today marks the dawn of a new era!

In other words, partially collateralized options represent a large contract value that can be controlled with a relatively small amount of capital. This aspect of options trading results in greater profits and losses than fully-collateralized options, providing traders, and ultimately markets, with better leverage and capital efficiency.

Opyn Partial Collateralization Overview

Users can now choose if they want to fully collateralize or partially collateralize a minted option.

If a user chooses to partially collateralize their trade:

  • For calls, less than 1 underlying asset can be posted as collateral
  • For puts, less than strike can be posted as collateral

With partial collateralization, excess capital is now free to either standby risk free or be deployed in another trade.

*There is a minimum size required for partially collateralized positions. The current minimums are 1 ETH for selling call options and 2500 USDC for selling put options.

Benefits of Partial Collateralization

  • Enhanced leverage for short options
  • Sell MORE options to generate HIGHER yield
  • Commit less capital, allowing more portfolio flexibility

Risks Associated with Partial Collateralization

  • Greater downside leverage
  • Under-collateralized positions will lead to forced liquidations
  • Possible to lose 100% of original investment prior to expiration

Margin Design

Margin is calculated using only a spot price, a shock to spot parameter, a conservative assumption on vol/premium, and time to expiry to give a worst case bound on the option premium.

Full details here.

Liquidation Mechanism

Sellers must maintain a minimum amount of collateral in their vault to secure the options they have sold. If a seller fails to do so, their vault may be liquidated and their collateral will be seized and auctioned off to repay their debts. The liquidation mechanism is a reverse dutch auction that is triggered via a Chainlink pricer with a specific timestamp.

The reverse dutch auction serves as the price discovery mechanism for Opyn liquidations.The reverse dutch auction starts at a low price and then the price increases over time — liquidators will execute the trade when it is profitable.

Full details here.

How to Sell Partially Collateralized Options

  1. Select the bid of your preferred strike price
  2. Enter the position size in the order box
  3. Toggle the partial collateralization button on to display the collateralization ratio, spot change %, and liquidation price
  4. Adjust the collateralization ratio or spot change % to set the position’s collateralization level
  5. For Call options, select the approve WETH Wrapper button, and confirm with MetaMask or your wallet provider. This step approves the Opyn platform to wrap your ETH, which will be used as collateral for the trade. For Put options, select the Approve Collateral button. This step allows the Opyn platform to approve your collateral for the trade.
  6. Select the Issue oToken button, and confirm the transaction. This action issues your oTokens for the selected options series
  7. Select Approve oToken button, and confirm the transaction . This action approves the 0xProxy contract to spend your oToken so you can sell it on 0x
  8. Select the Sell oToken button, and confirm the transaction. This action sells your minted oToken on 0x
Select Bid, Toggle Partial Collateralization On, Set Parameters

Important Terms:

Collateralization Ratio

  • Collateralization ratio represents the amount of collateral used to secure the options contract. Users can choose a collateralization ratio for the options position. A trade with a 100% collateralization ratio means the options position is fully collateralized. A trade with a 50% collateralization ratio means the options position is secured by 50% of the contract’s max loss.
  • The collateralization ratio is calculated by: collateral / max loss
  • Max loss is (1 asset for calls, strike for puts)
  • *note: the collateralization ratio automatically adjusts if a user changes the spot change % input
  • The minimum collateralization ratio will change over time. As the option gets closer to expiration, the minimum required collateralization ratio decreases. In other words, not every option has the same minimum collateralization ratio

Spot change %

  • Spot change % represents the percentage change in the underlying asset price that would cause the liquidation process to start for the options position. For example, a spot change of 200% means that a 200% change in the price of the underlying asset would cause the reverse dutch auction to commence. For calls, the spot change % is positive because an increase in the spot price moves against the call option writer. For puts, the spot change % is negative because a decrease in the spot price moves against the put option writer.
  • The spot change is calculated by: liquidation price/current price — 1
  • *note: the spot change % automatically adjusts if a user changes the collateralization ratio input

Liquidation price

  • The liquidation price represents the underlying price at which the reverse dutch auction would start
  • The reverse dutch auction serves as the price discovery mechanism for liquidations

Important Partial Collateralization Characteristics:

  • There is a minimum size required for partially collateralized positions. In order to ensure the safety of the system and make sure liquidators and incentivized to liquidate vaults even in high gas environments, we must have a minimum size required to create a partially collateralized vault. This is similar to MakerDAO’s dust, which is the minimum requirement for opening a Maker vault to mint DAI. The current minimums are 1 ETH for selling call options and 2500 USDC for selling put options
  • As the collateralization ratio decreases, so does the spot change % until liquidation. In other words, a lower collateralization ratio means a smaller change in the price of the underlying asset can cause the position to be liquidated
  • Time until expiration factors into the minimum collateralization ratio. Less collateral is required to secure options that are closer to expiration. This is why the minimum collateralization ratio is different for each option

Partial Collateralization Examples (*numbers made up for ease of understanding)

Collateralization Ratio 100%

  • Option: 2400 call
  • Option Expiration: < 1 week
  • Current ETH Price: $1815
  • Collat Ratio: 100%
  • Spot change: N/A
  • Liquidation Price: Infinity

Alexis has 1 ETH and wants to sell call options to earn yield. She wants to fully collateralize her position to avoid any possibility of being liquidated. Alexis can either leave the partial collateralization toggled off or select a collateralization ratio of 100%. By fully collateralizing her short position, Alexis can only sell 1 call option, but she won’t be liquidated.

  • Trade Date: July 3
  • Option Expiration Date: July 9
  • Amount of Calls Sold: 1

On July 4, the price of ETH rises to $1900

On July 5, the price of ETH rises to $2000

On July 7, the price of ETH rises to $2075

On July 9, the settlement price of ETH is $2050

Since the price of ETH stayed below $2,400 on the expiration date, Alexis’ option expires worthless and Alexis can redeem the premium + her full collateral.

Collateralization Ratio 50%

  • Option: 2400 call
  • Option Expiration: < 1 week
  • Current ETH Price: $1815
  • Collat Ratio: 50%
  • Spot change: 20%
  • Liquidation Price: $2178

Aparna has 1 ETH and wants to sell call options to earn yield. She wants to partially collateralize her position so she can sell more than one call option and earn more premium. Aparna toggles the partial collateralization button on, and selects a collateralization ratio of 50%. By partially collateralizing her short position with a 50% collateralization ratio, Aparna can sell 2 call options, but she has the possibility of being liquidated if the price of ETH moves to her liquidation price of $2178.

  • Trade Date: July 3
  • Option Expiration Date: July 9
  • Amount of Calls Sold: 2

On July 4, the price of ETH rises to $1900

On July 5, the price of ETH rises to $2000

On July 7, the price of ETH rises to $2075

On July 9, the settlement price of ETH is $2050

Since the price of ETH stayed below the liquidation price of $2178 before the expiration date, Aparna’s options expire worthless and Aparna can redeem the premium + her full collateral.

Collateralization Ratio 33.3%

  • Option: 2400 call
  • Option Expiration: < 1 week
  • Current ETH Price: $1815
  • Collat Ratio: 33.3%
  • Spot change: 12.5%
  • Liquidation Price: $2041

Zubin has 1 ETH and wants to sell call options to earn yield. He wants to partially collateralize his position so he can sell more than one call option and earn more premium. Zubin toggles the partial collateralization button on, and selects a collateralization ratio of 33.3%. By partially collateralizing his short position with a 33.3% collateralization ratio, Zubin can sell 3 call options, but he has the possibility of being liquidated if the price of ETH moves to his liquidation price ($2041).

It’s important to note that as the collateralization ratio decreases, so does the spot change % until liquidation. In other words, a lower collateralization ratio means a smaller change in the price of the underlying asset can increase the risk of the position being liquidated. That’s why the liquidation price is lower for Zubin’s options than it is for Aparna’s partially collateralized options.

  • Trade Date: July 3
  • Option Expiration Date: July 9
  • Amount of Calls Sold: 2

On July 4, the price of ETH rises to $1900

*On July 5, the price of ETH rises to $2000

**On July 7, the price of ETH rises to $2075

On July 9, the settlement price of ETH is $2050

As you can see, the price of ETH moves close to Zubin’s liquidation price of $2041 on July 5th, and then moves above Zubin’s liquidation price on July 7th. Let’s look at two scenarios, 1) Zubin adjusts collateral to avoid being liquidated, and 2) Zubin does NOT add collateral to his vault before the reverse dutch auction starts the liquidation process.

Scenario 1: Zubin adjusts collateral to avoid being liquidated

On July 5, the price of ETH rose to $2000, close to Zubin’s liquidation price of $2041. To avoid the possibility of being liquidated at $2041, Zubin goes to his Dashboard, selects his short position, and then adds collateral to his short position vault. By adding collateral, Zubin increases his collateralization ratio, increases the spot change % until liquidation, and increases the liquidation price of his position. Zubin’s new collateralization ratio is 50% and his new liquidation price is $2178.

Since the price of ETH stayed below Zubin’s new liquidation price of $2,178 before the expiration date, Zubin’s options expire worthless and he can redeem his premium + his full collateral.

Scenario 2: Zubin does NOT add collateral to his vault before ETH increases past his original liquidation price of $2400, causing the reverse dutch auction to start the liquidation process

On July 7, the price of ETH moved above Zubin’s liquidation price of $2041, causing the reverse dutch auction to start.

The reverse dutch auction serves as the price discovery mechanism for Opyn liquidations.The reverse dutch auction starts bidding for Zubin’s collateral at a low price and then the price increases over time — liquidators will execute the trade when it is profitable.

Zubin’s Liquidation Example (numbers made up for ease of understanding):

​​Zubin sold 3 call options, and the margin required for each option was ~$266 (33.3% collateralization ratio on $2400 call = ~$799 total), but each option is worth $200, so $799 margin is required total to cover options worth $600 total. However, let’s say only $700 of collateral is in the vault, so the vault is in the liquidation zone.

​​The system seizes the vault and tries to buy the options that were minted from the vault by offering some of the collateral in the vault in exchange for those options.​​

The reverse dutch auction will first bid a very small amount of collateral for the 3 options, say $6, or $2 each. No one will execute this trade.

​​Then, a few blocks later, Opyn’s bid will be $100. No one will execute this trade. This process will be done continuously on a per block basis.

​​Quite a while later, opyn will raise its bid to $550. At this point, a liquidator might execute this trade, if not, someone will definitely a few blocks later when Opyn raises its bid to $600, assuming gas is less than $100.

Reasons to Avoid < 40% Change in Spot

It’s recommended that you do not input a spot change % less than 40%. This will cause your vault health to start in the warning or dangerous zone, which could lead to your options position being liquidated from small moves in the price of the underlying asset.

Adjusting your collateral also costs gas, so significantly under-collateralizing your position to start could become expensive over time.

How to Monitor Partially Collateralized Vault Health

Close Position

To close a partially collateralized short position:

  • Go to the Opyn v2 Dashboard (make sure the Active Positions tab is selected)
  • Select the short position that you want to close
  • Select the Close Position button
  • Enter the oToken amount to reduce or fully close out your position, then click “Buy Back oTokens” and confirm with MetaMask. This action buys back your minted oTokens from 0x contract
  • Re-enter the same oToken amount in the close position box, then click “Burn and Withdraw” and confirm with MetaMask. This action burns your oTokens and redeems your collateral. This action needs to be taken in order to reduce or close out your position.
Close a Partially Collateralized Short Position

Adjust Collateral

To adjust collateral for partially collateralized short positions:

  • Go to the Opyn v2 Dashboard (make sure the Active Positions tab is selected)
  • Select the short position that you want to add or remove collateral
  • Select the Adjust Collateral button
  • Select Add or Remove and adjust collateral
Adjust Collateral for a Partially Collateralized Short Position

Manage oTokens

To manage oTokens for a partially collateralized short position:

  • Go to the Opyn v2 Dashboard (make sure the Active Positions tab is selected)
  • Select the short position that you want to manage
  • Select the Manage oToken button to issue or burn oTokens
  • Select the issue tab to issue oTokens or select the burn tab to burn oTokens
Manage oTokens for a Partially Collateralized Short Position

Appendix

What Is Collateralization?

Collateral is an asset used as security for an options contract. Collateralization is the amount of that asset required to secure the options contract. If the borrower defaults on their contract obligation, the lender may seize the asset and sell it to offset the loss.

Collateralization gives lenders a sufficient level of security against counterparty risk (default risk). Due to the volatile nature of crypto assets, most protocols have a minimum collateralization requirement of 100% (often more) for derivatives contracts. This is incredibly capital inefficient for the DeFi ecosystem.

What is Partial-collateralization?

Partial collateralization is when the amount pledged to secure an options contract is less than the value of the contract’s maximum loss. Partial collateralization benefits traders because less money is required to secure the options contract, allowing the trader more flexibility with assets in their portfolio.

For the flexibility of providing less capital upfront, partial collateralization also requires a security agreement that gives the smart contract authority to sell the collateral (liquidate) if the market moves against the position and the collateralization level is too low.

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.
  • 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. Opyn v2 is cash settled.
  • 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

Opyn Community

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