Ubiquitous yet nowhere to be found: On-chain options
Defining options for the on-chain options market.
Abstract
Innovative cryptocurrency protocols rely heavily on option theory, and proper option pricing and trading mechanisms are necessary for risk management in the crypto world and fair rewards to liquidity providers.
However, options trading is currently lacking critical infrastructure, and current on-chain methods are not equipped to handle the growth of the options market. The SYMMIO technology is essential for meeting the demands of this growing market.
Summary
Introduction: options are the next kid in the crypto-town. SYMMIO will help define the on-chain option market.
Options, which give the right to buy or sell assets at predetermined prices, are ubiquitous in crypto since all Dex liquidity is staked in automated maker pools with the same purpose. Options are needed to enrich if not revolutionize Dex experience.
Options are necessary to effectively manage risk, especially when leveraging is involved. For the on-chain options market to grow and develop, advanced technologies similar to those developed by SYMMIO are required.
Options are needed to define and achieve the fair rewards of Dex liquidity pools.
Option-pricing theory can be used to analyze Dex pools since their assets can be bought and sold at predetermined prices. Accurate option prices are necessary to calculate a fair APR for the billions of dollars locked in Dexes.
What solutions can be proposed to fairly compensate liquidity providers for the options they implicitly issue, when Dex trading fees and potentially inflationary rewards are not enough?
- Liquidity providers (LPers) in the crypto space face a risk known as impermanent loss, also known as volatility risk or gamma risk in the options markets. Because LPers issue options, option prices are necessary to assess the fair pool APR.
- GammaSwap, Smilee and Panoptic create tools that can create a market for APR. In a nutshell, anyone who believes that the IL will be greater than the pool APR can pay an extra premium (enhancing the pool APR) for the benefit of taking away all the impermanent gain (minus the impermanent loss).
- Because a market for pool APR is a separate, smaller market for volatility, it can only be smoother with market-wide volatility prices, that is, option prices. It can also only function better with a deep option market. Which would provide additional tools to enhance the rewards of liquidity providers.
Overall, we believe that an effective option market is necessary for the success of next-generation crypto protocols and that these protocols, as well as liquidity providers (LPers), will help to further develop and strengthen the on-chain option market.
Options are crucial bricks in the financial lego. Defi as the greatest financial lego. It needs options to grow, and its lego feature may feed the on-chain option market and make it thrive.
Options are still Defi’s invisible man.
Options are also much needed for risk management, especially whenever there is leverage.
Whenever there is leverage, there is liquidation or bankruptcy risk. Crypto assets involve large tail risks due to the presence of whales, hacks, dumps, and trading bottlenecks.
Only options can provide a liquidation-free experience, protecting you from jumps and other extreme risks typical of crypto.
Options have the potential for wide-scale use in crypto.:
- they are needed for the largest players: protocols need options to ensure they will fulfill their commitments
- they are needed for leveraged traders to control liquidation risk, with ideas such as insured PERPs.
Options must be accessible at all times and at a fair cost. Currently, options are largely unavailable for these strategies, with some insured PERP protocols only providing leveraged trading without the insurance component.
On-chain options manufacturing techniques cannot scale and cater market need. SYMMIO is needed.
All efforts to create an on-chain options market should be applauded, and while current initiatives are highly appreciated, they cannot fulfill the demand for a cost-effective, scalable option market.
The two main types of experiments are option vaults and option replication.
- Vaults, where users provide liquidity to sell overpriced options, can only work as long as the options market is inefficient. The market cannot scale with overpriced options. Vault protocols may also benefit from a deeper option market to provide refined strategies.
- Replicating options requires cheap and available liquidity. Delta hedging using the liquidity of leveraged PERP-like protocols is problematic: hedging is not possible when maximum capacity (open interest) has been reached. It is costly as soon as books are unbalanced.
SYMMIO tech is fully suited for the options market.
SYMMIO’s tech can be used to bring sufficient liquidity to enable on-chain delta hedging; it can help bridge options from the most liquid markets, especially since tradfi exchanges sometimes also rely on AMFQ tech for options.
We argue that SYMMIO’s ability to securely bridge options and use its AMFQ tech to animate an on-chain option market would be hugely useful for all protocols:
- Option manufacturing protocols need deep liquidity to replicate options, and possibly AMFQ strategy to market them, especially the less liquid options
- Option-enhanced strategies such as insured PERPS need guaranteed option availability to scale up at competitive costs
- LP structuring, slicing, and concentrated liquidity need reliable option prices to perform optimally
Once a scalable and functioning on-chain option market is created, the contributions of all these protocols can greatly enhance it.
We suggest a roadmap for development be discussed with the community.
II) Analysis
The basics: Dex liquidity is always about options
Options are essential tools for risk management and speculation.
Purchasing a put option, which gives the holder the right to sell at a predetermined price, can protect leveraged entities, traders, and protocols from financial ruin. Furthermore, it limits downside risk.
Buying a call option, which gives the holder the right to buy at a predetermined price, grants exposure to potential upside gains, but not downside risk.
This right comes at a cost, known as the option price or premium. Options can be sold on the secondary market.
But wait, if you never heard of options, maybe you want to ask, buying the right to buy at a certain (strike) price… isn’t this just like paying someone to leave of limit sell order (at that strike price) in an order book?
Pretty much so, knowing that this right belongs to the option buyer and can be used by him anytime until the maturity of the option.
The next wave of crypto innovation
Options are implicitly ubiquitous in crypto. Options can be an important narrative, and enable important innovations.
Crypto-trading Dexes can be analyzed through the prism of options. The basic reasoning is that anyone who submits a buy or sell order at a limit price is in effect providing liquidity to a market, and deserves to receive a premium for that.
Because a Dex pool is an automated order book, it is similar to a series of options. LP providers in a BTC-USDC pool pre-commit to buying BTC when its price drops, which is the equivalent of issuing put options. They also pre-commit to selling BTC when its price rises, which is effectively issuing call options. The selling of both calls and puts is known as a short straddle, and LP providers should be rewarded for this with a premium, the APR, that can be calculated using option prices.
Do you receive the correct APR in the pool you provide liquidity for? The only way for you to know it is to use an option-pricing framework.
What’s the next wave of innovation? Building on these concepts to provide solutions. For instance, if the farming incentives are not sufficient, the liquidity in the LP can be used to earn fair, i.e. market-consistent option-like rewards.
Innovation 1: LPs as option books. GammaSwap and Panoptic
Both of these protocols use option pricing theory to break down Uniswap-style LPs, which can contribute to creating a market for APR and the risk of impermanent loss. However, possibly due to the underdeveloped option market, they do not involve options (or oracle prices) in their operations. Hence, they call to themselves as “oracle-free.”
- Panoptic aims at slicing Uniswap LP, anLP to option transformation.
- Gammaswap aims to enable arbitrage between the farm APR and the market-consistent price of providing options.
If the farm APR does not reward the risk of impermanent loss, then users are better off holding the two assets rather than farming them. They can borrow the assets from a LP staked in Gammaswap and simply hold them, then return the assets to the LP at the end of the period. Additional rewards for LP holders, and the possibility to have a positive exposure to volatility/gamma risk for traders, and earn more than the farm APR too.
LPers receive an APR in exchange for taking on the risk of impermanent loss (IL), the difference between the LP value and the value of holding its two assets separately.. . . . . . . .. . . . . . . .. . . . . . . . Details: In the blue curve, LPers only take on the risk of impermanent loss and receive a predetermined APR, which is added to the red curve. If they lend out their LPs for external use, they can receive an additional APR, shown by the green curve. To illustrate this, assume a 5% APR plus a 5% lending rate per month.
These graphs show a Uniswap implementation of Solidly where the APR is known ex-ante and does not depend on the amount of trading in the LP. Note that impermanent loss is a complex concept since it is not a realized gain (unless the two assets are effectively borrowed then LPed). Long-gamma strategies are much easier to understand.
In DEFI, the typical way to earn yield is to accept the risk of impermanent loss. Soon, traders will enjoy long exposure to volatility and gain from price movements larger than the APR, thanks to farmers who lend their LPs. This strategy actually is easy to understand since traders realize their gains when they return the assets.
Although these strategies are mainly oracle-free in their current version, they can benefit from a deeper options market:
- Pricing APR and its arb strategy actually require an implied volatility measure, which is not oracle-free.
- Once a market for APR is more firmly established, options can be used to enhance arbitrage opportunities. For instance, part of a locked LP could be restructured and sold as options.
Overall, LP slicing protocols such as Panoptic and Gammaswap would greatly benefit from SYMMIO bridging options on-chain. Reciprocally, a newly created on-chain option market would greatly benefit from these protocols’ liquidity.
Innovation 2: protected leverage. Option-protected PERPS
Options can be used for upside exposure without the risk of liquidation. This can take two equivalent forms:
- a call option, which only pays out in case the terminal price is greater than the strike price
- a protected leveraged long exposure, for instance, protected PERP, where the benefits from upside movements in the underlying, without risking liquidation
If your strategic view is that Ethereum (ETH) will increase significantly in value next week, but that there is a potential for a minor price retracement in the coming days, how can you create a leveraged position without being at risk of liquidation? Suppose ETH is worth $2,000.
- With a 10x exposure, your portfolio is worth zero if ETH touches $1,800 (so you get liquidated at $1800 plus a safety margin).
- if you add 10 put options that give you the right to sell ETH at $1,800, your portfolio has zero risk of being underwater. You avoid liquidation risk.
- this setup is in fact equivalent to buying 10 ETH call options at strike $1800
Strategies such as those being developed by Dopex, including their “Insured PERPS,” are necessary for retail to make strategic leveraged bets. Unfortunately, Dopex lacks the liquidity to make these bets sizeable. See the “Insured PERPS” section of their website.
Chart: despite a very hype product, Dopex has experienced a very mild growth only in TVL (source: defillama:dopex)
Dopex (see their medium article) currently sources leveraged funding via GMX, then insured the leveraged position with a put option. They need to overcome two limitations: first, scarcity of on-chain put options; second, high cost of GMX leverage (see preview reviews of vAMM and FX )
The analysis above could also be applied to:
- Hegic designs nice option combos on ETH and BTC, but which, at the time of writing, only has liquidity for at-the-money options
- Psyoptions and Olive which also provide option-protected vaults (e.g. covered-called), to be enhanced by deeper liquidity
SYMMIO, and the development of a broader option market, could largely increase the liquidity available to these protocols while diminishing their costs.
III) Option manufacturing protocols
Option manufacturing protocols as needed. Current experiments cannot cater the need for a deep on-chain option market
All initiatives to cater to the need for on-chain options must be cheered; their limitations must be analyzed carefully to improve DEFI. And main techniques, while much needed today, cannot scale.
The two main routes taken are:
- perpetual option protocols
- option sourced from vaults to which users provide liquidity
These are arguably not conceived to scale:
- perpetual option protocols, which currently only manufacture short-term options
- option vaults require an overpriced options market
Current on-chain option experiments also face costs issues:
- As a reminder, traders in synthetics protocols are often unaware of the costs of borrowing thin liquidity. Andrew Kang paid a whopping $16 million fee to the GMX GLP, out of his $18 million profit.
- We argue that traders’ costs would be both higher and less noticeable with synthetic options. Traders would need to understand not only the cost of liquidity but also the complex relationship between the asset price and the option price.
Technique 1: perpetual option protocols
In traditional finance, future instruments enable leverage, with contractual delivery ensuring convergence of the future price to the security delivered at maturity.
Perpetual futures do not have a maturity or settlement date. PERP price convergence is forced by a funding fee, which over one day equals the differential between the PERP price and the spot price: if the PERP price trades 2% above the spot price, long traders pay a daily 2% funding fee to short traders. Similar mechanics exists in oracle-price-virtual-AMM protocols, which trade at oracle price but charge a rollover and funding fee that increases with unbalance in books.
PERP and vAMM mechanics are potentially costly for traders, but at the same time have been successful in creating new on-chain markets, and can always be complemented with deeper and cheaper liquidity when it needs to scale up (see e.g. a review of vAMM protocols).
This PERP funding mechanics could potentially work for option prices, provided one is able to devise accurately the true option prices.
This is currently not the case. In their Everlasting options founding research paper, Paradigm defines the daily funding fee as the difference between the PERP option price and the underlying price, rather as the difference between the PERP and the true option price.
Example and definition: suppose the BTC price is $30k; a call option with strike $32k and 3 months maturity has a positive value, because there is a positive probability that the Bitcoin price vastly exceeds $32k in 3 months. The option price increases with the volatility of the BTC and with the time to maturity: the greater the vol and the time, the higher the probability of gains.
This option is called out of the money: if exercised today, it would have zero value. It is also said to have zero intrinsic value. In this case, all the option value is called the time value. When BTC is above strike price of $32k, it is said to be in the money (would yield gains if exercised).
This in effect means that the half-life of so-called everlasting options is daily. Paradigm options die rather than last.
Longer maturity options are needed for strategic bets, insured leverage, LP slicing, and APR arbing.
Option manufacturing technique 2: user-provided vaults
A few protocols manufacture options based on user deposits.
Their typical rationale is that since on-chain options are scarce, traders are sometimes ready to pay a premium on top of market price, which is equivalent to the opportunity to earn yield for retail investors.
Overpriced options are not sufficient to cater to the need for on-chain options. Vault protocols may also benefit from a deeper option market to provide refined strategies and better alignment with users.
Notably, price discrepancy must be considered a source of arbitrage, not of yield.
That the BTC (or your fav shitcoin) price is 2% cheaper on-chain does not mean that holding BTC over one year generates a 2% yield. It solely means that BTC can be sold off-chain and bought on-chain simultaneously, generating a 2% instantaneous gain called arbitrage gain.
Likewise, incentivizing users to lock in capital and risk it to issue options deemed expensive may not be the perfect recommendation for users who may unwillingly face high tail risk. Expensive option prices may however be an interesting entry point for directional trades: selling an overpriced call option is sometimes the best way to take a profit while being paid for it.
As a matter of fact, modeled option prices depend on the ability to manufacture them and on the riskiness of the capital involved in their replication. Delta-hedging options require involve much less risk than selling unhedged options, because the capital provided may be entirely wiped out by adverse movements.
As a consequence, a user that passively provided capital to a vault requires much higher rewards than the manufacturer of an option.
Vault option protocols may thus find it hard to scale and cater to the market need on their own.
This analysis could also be applied to other protocols which provide option-like payoffs, and have globally not been performing very well:
- Opyn has an option-like payoff (such as squared Eth) partly replicated with a funding fee rather than options. These products have not been performing well (squared Eth has underperformed as designed in down markets, but they have barely done as well as Eth in up markets)
- Zeta aimed to provide perps, futures, and options and is currently relaunching as Perp-only, which indicated the need that more options to be made available.
- IVX is launching with the aim to replicate options, that is, issue and delta-hedge them. IVX intends to use GMX to trade underlying assets, which has important limitations: firstly, when GMX is at full capacity, it becomes impossible to hedge! Secondly, the greater the liquidity utilization, the greater the costs. Thirdly, GMX only enables the trade of a limited number of assets.
Conclusion
With the understanding that any LP can be decomposed as a string of options, the crypto-industry is now fully embracing modern finance theory, which largely revolves around options.
Options are hugely needed:
- to price strategies (optimal fees, APR, LP slicing)
- to hedge protocols and their users
- to manufacture sophisticated structured products which mix leverage and liquidation protection
Interestingly enough, options trading in traditional finance is usually AMFQ-based, because vendors cannot entirely pre-commit their available liquidity to all different option specifications (price and strike) for the same asset.
The use of AMFQ means that the SYMMIO tech can be directly adapted to bridge trad-fi options on-chain (and possibly, later on, to participate in the evolution of the on-chain option market).
Overall, the current option manufacturing protocols are not sufficient to cater to the needs for on-chain options. SYMMIO’s tech can be extremely useful, first to bridge options on-chain, and secondly, to assist the development of a deeper on-chain robust option market.
