Understanding DeFi Options
A quick overview on basic options concepts and applying them into the DeFi context
TL;DR
- Options are a well-known type of derivatives in conventional markets. They represent a contract between the buyer and the seller.
- The contracts can have different formats and are used for multiple reasons. The one we are most interested in at Pods is the use of options to hedge.
- Such contract rules can be transported from traditional finance to a simple ERC20 within the DeFi space, and that’s what we call DeFi Options (Decentralized Options). But to get there, many details need to be addressed and adapted.
- The main advantages of DeFi Options are its inherent composability characteristic and its reach. Anyone in the world can access DeFi options, and they can relate to any asset with an ERC20 representation.
- For this reason, DeFi options represent a significant step towards democratizing the access of sophisticated tools (such as options), helping increase one’s portfolio stability and returns. For the first time in history, users can access such assets in a game-changing way.
- Disclaimer: DeFi is a highly experimental technology, and its risks are not be underestimated. Be aware of it while using DeFi protocols, and never allocate funds that you are not ready to lose.
Understanding DeFi Options
What are options?
Options are one of the most common derivatives types in traditional finance, and they represent a contract between the buyer and the seller of the option. An options contract offers the buyer the opportunity and optionality to buy or sell an asset at a pre-accorded price (which we call strike price) at the same time that it represents an obligation for the option seller to buy or sell the asset from/to the buyer.
One could think of it as a type of financial instrument with specific conditions, such as “if this then that.”
Here is a quick video giving you an overview on how to read the options series in our application and how to evaluate whether it is interesting or not to exercise the option bought:
What are calls and puts?
There are two types of options: calls and puts. Each one represents a specific action that will be secured to take place in the future if a particular condition is met.
Call options guarantee the buyer the right to buy the underlying asset at the strike price, while put options guarantee the buyer to sell the underlying at the strike price.
What are American and European options?
Being American or European options describes how the buyer can exercise its contract.
The American options allow the buyer to exercise his right to buy or sell until the contract’s expiration. On the other hand, when the option’s exercising type is European, the contract buyer can only exercise his right after the expiration date.
In our implementation of DeFi Options, users can only exercise their options during the exercise window.
What are cash and physical settlement?
An option can also be exercised in two ways: through cash or physical settlement.
The cash settlement happens when both parties agree that only the counterparts’ payout difference will be offset. The primary outcome of this is that the underlying asset will not have its owner changed. Let’s visualize this through the following example:
Adam sells an American put option to Sam where the underlying is ETH and the strike price $1500. Sam decides to exercise the option when the price of ETH drops to $1000. Instead of sending 1 ETH to Adam, Sam receives the strike price minus the spot price (1500–1000), resulting in $500.
As the name suggests, the physical settlement happens when the underlying asset in custody will be sent from one counterpart to another once the option is exercised. Taking the previous example, in this case, Adam would have paid $1500 to Sam, and Sam would have sent the 1 ETH to Adam.
Currently, our DeFi Options use physical settlement. This means that whenever a user wants to exercise the options they hold, they have to send the total amount of underlying asset they are exercising to the contract to receive the contract’s collateral.
What is the premium?
The premium is the price of the option in the market. It represents the compensation of the option seller to write and sell the contract. It can also be seen as the cost that the option buyer has to hedge his current position. The premium is paid upfront.
There are many methods to price the options, and, in Pods’ protocol, the chosen method was to use the Black-Scholes model for pricing European options.
What is the strike price?
The strike price is a parameter in the option contract. It represents the price at which the underlying asset will be exchanged in case of exercising the option.
In the case of call options, the strike price represents the option buyer’s price to buy the option seller’s underlying asset. The strike price is the price that the option buyer will sell the underlying asset to the option seller for put options.
What is the underlying asset?
The underlying asset is the asset that is being negotiated to be bought or sold if the option is exercised, and usually, it is the volatile asset.
So, when we say that the underlying of the option is ETH, we are saying that, in the case of a put option, if the price drops below the strike price and the buyer exercises his right, the ETH is the asset that will be sold at the strike price to the option seller.
The same logic applies to the call options, but instead of being the asset sold, it will be an asset bought at the option buyer’s strike price.
What is the collateral asset?
In Pods’ case, the collateral asset is the asset that the option seller will have to lock in the contract to guarantee that the transaction will be respected once the option buyer decided to exercise the right to either sell or buy.
- In the case of a put option of ETH:USDC, the collateral asset would be the second asset as the option buyer would sell the ETH for the accorded price in USDC.
- In the case of call options on ETH:USDC, the collateral asset would be the ETH, as the option buyer would exchange his USDC for the option seller’s ETH.
When is it worth it to exercise an option?
Let’s say that Danna has bought a European put option on ETH:USDC with the strike price of 1800 USDC that will expire in few hours. How can she evaluate the situation if it will be profitable for her to exercise the option or not?
In the market, we say that an option can be in-the-money, out-of-the-money, or at-the-money.
Let’s see what they mean below.
- In-the-money
This refers to the situation where exercising an option will be profitable for the option holder.
In the case of put options, if the strike price is higher than the spot price (market price of the asset), we can say that it will be profitable for the option buyer.
That means that if she exercises her option she’ll sell the asset at a higher price than the market to the option seller, as agreed before. So, if the strike price of the ETH is currently at 1000 USDC, we can say that Danna should exercise her option so that she has a profit of 800 USDC.
- Out-of-the-money
This refers to when exercising an option won’t be profitable for the option buyer and may incur losses.
Let’s see the example of Danna again but now with the spot price at 2000 USDC. Why would she sell her ETH for a lower price than what the market is pricing the asset for? In this case, if she exercises her option, she would be selling her ETH for 1800 USDC and would lose a potential profit of 200 USDC.
- At-the-money
This refers to the situation when the spot price is equal to the strike price.
In this case, the option holder should mainly consider whether keeping the underlying asset, which in the case of Danna is ETH, is desired or not.
If you are interested in better understanding options payout, check this section in our documentation.
Pricing and Trading
One of the main differences between conventional options and DeFi options is where they can be traded and how they are actively priced.
In conventional markets, options are normally traded within orders books, and markets have an extensive network of market makers that constantly price and place orders for different options markets.
Pods Protocol adopts a different approach to the pricing and trading venue of our DeFi options. Within our protocol, options are represented as ERC20 tokens and are traded in our Options-Specific AMM.
An AMM, short for Automated Market Maker, is how DeFi space handles buy and sell orders to relace order books. By having liquidity pools for options and stablecoins, the protocol can guarantee liquidity for trades to happen at any time. The liquidity providers receive fees from trading activity.
The Options AMM allows for single-sided liquidity provision while algorithmically prices the options based on market conditions and Black Scholes.
General derivatives price formulations use one or more data from the market (like the spot price of the underlying asset) to calculate a derivative price. Our model’s price discovery mechanism uses external factors, combined with computed properties (such as time to expiration and risk-free rate) and internal factors (such as the Implied volatility), to calculate the current premium according to Black Scholes. For more details on pricing, check Pricing section in the documentation. It accounts for a programmatically update on each option’s implied volatility based on the pool’s conditions.
Because of the options AMM characteristics, the protocol allows for several unexpected flows.
For instance, one of them is providing options tokens as liquidity to the pool and earning fees. Therefore reducing the cost of the hedge bought and allowing options tokens to be smarter within themselves.
Collateralization and Counterparty Risk
Currently, our protocol requires 100% of collateralization. This means that there is no counterparty risk. Counterparty risk is a known risk in traditional finance that describes the possibility of default on the contract by the other party. In the case of the options contracts, it is the seller.
For example, in the case of a put option, the seller needs to lock in the collateral asset (which is the stablecoins). Once the option is bought, the buyer will pay the premium upfront, and once decided to exercise it, the buyer needs to deliver to our contract the Pods option token and the underlying asset (let’s say ETH). Once doing that, the smart contract will send each of the counterparts the respective asset negotiated in the option contract. The transaction was trustless since the smart collateral guarantees that the seller will receive the underlying and the buyer will receive the collateral asset.
Beware of Risks
DeFi is a highly experimental technology, and it has all sorts of risks. We’re working on a post to disclose all types of risks we can map while interacting with our protocol. Meanwhile, please be aware of risks and don’t ever invest or allocate funds in DeFi that you are not ready to lose.
Why DeFi options are game-changing
DeFi options are:
- Composable
- Collect pieces of other protocols (like in our case, Aave) to make its use more efficient.
- Easy to integrate
- Building on top of DeFi options is accessible since the options contracts are represented in ERC20 tokens.
- Trustless
- No need for intermediaries. Smart contracts will do the work.
- Prices are updated algorithmically
- And trading is available 24 hours a day, seven days a week.
- Accessible to anyone in the globe
- There is no need to be an options trader, a private banking client, or an institution to access hedging solutions.
And now can be traded like never before, borderless and limitless.
We’re excited to hear how you have used options or why you are looking forward to using DeFi options. Join our Discord and let us know!
That’s it for now. 😊
Now that you have a basic understanding of DeFi Options, the next step is learning how they work in detail. Stay tuned for the following posts. 🙏🏻
Thanks for reading!
About Pods
Pods is a decentralized non-custodial options protocol. Users can create options and trade them through an Options AMM on the Ethereum Blockchain. Pods is the easiest way to hedge crypto in DeFi.
We invite you to take the first step in your new mission: start testing the app on app.pods.finance
Join the Pods community
app | website | documentation | blog | twitter | youtube | telegram | discord
