Hackernoon logoOptions Trading Get A Huge Shot in The Arm with The Arrival Of DeFi by@yankjing

Options Trading Get A Huge Shot in The Arm with The Arrival Of DeFi

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Yank_Jing Hacker Noon profile picture

@yankjingYank_Jing

DeFi Fanatic

Decentralized Option Trading Market and Asteria Protocol

Expecting Explosive Growth of Crypto Option Market

For the last couple of years, the cryptocurrency options market received massive attention, which I believes is the inevitable trend.

First of all, in the traditional financial market, options volumes are usually at least double digits times of spot and futures markets combined, while right now in crypto, the situation is almost the opposite.

And the expansion of cryptocurrencies market is no more than a replication of the traditional market with only faster speed, that means there is at least a 100x potential growth of options market to be expected.

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Secondly, options are the way to provide anyone with low risk and high leverage trading schemes which are current major crypto investors are looking for actually.

Thirdly, the volatility is far more active in cryptocurrencies, especially when DeFi coins enter the arena. Options then would be the best environment for crypto players on either hedging needs or speculating purposes.

This article would be focusing on analyzing the options trading scene of cryptocurrencies, and with some introductory information of options- related knowledge here and there, for readers who are not with expertise in this area.

1.1      Statistics

Numbers tell you all:

For BTC Open Interest

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As we can see the Daily Open Interest (Daily total number of option contracts that have been traded but not yet liquidated) rose from less than 100 million from Jane 2019 to 1 billion in May 2020 and surged into 14 billion in March 2021, so 140x times growth in such short period.

For BTC Trading Volume

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There were only less than 100 million at the beginning of last year, and it took 1 year to break the 1 billion mark, but only 3 months to reach 2 billion in March of 2020.

So, at this accelerating pace, simple math gives us that the yearly market size of options would be achieving trillions in the very near future. No questions asked.

1.2         Market Maturity

Not only the total OI and trading volume make options trading of cryptocurrencies a legitimate market for any investors, to give more professional evaluations, the comparison of volatilities between traditional S&P 500 and BTC options are conducted here.

With the formula

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to calculate the historical volatility. We have the following graph for the S&P 500 and BTC of Jan-May 2020, thanks to Kaiko:

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And with formula

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to compute each trading day the average implied volatility for at the money options (ATM)

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From the comparison, we can easily conclude that, other than the Crypto Black Thursday’ of March 12th, 2020, during when the numbers are out of the chart, implied volatilities of at the money (ATM) options did converge back quite soon, showing the strong willing of market makers to trade Gamma in this volatile environment. And Implied to realized volatility ratios averaging around 110% to 120% of the same magnitude of the developed market such as SP500 options.

Simply put, after a few years of development, BTC options showed clear indications of maturity both in terms of costs (implied to realized ratios) and trading behaviors of market participants.

2.    Why Options a Best Fit for Crypto Currencies

Option 101

Some basic information for newbies in options trading:

Basic Types:

Call: The right to buy the underlying asset

Put: The right to sell the underlying asset

Elements:

Strike Price, the price for the buy or sell of the underlying specified in advance. For cash settlement, which is most applied in crypto options, the strike price can be equal to the buy/sell price. The profit of the option buyer is the difference between the spot price and the exercise price at the time of delivery.

Premium, the option price paid by the buyer of the option, that is, the cost that the buyer pays to the option seller to obtain the contract.

Option prices/Premiums are mainly composed of two parts: Intrinsic Value and Time Value.

Intrinsic Value

Embedded value refers to the total profit that can be obtained when the contract is executed immediately.

In the money (ITM): When the exercise price of a call option is lower than the actual price at the time, or when the exercise price of the put option is
higher than the actual price at the time, the intrinsic value of ITM option is the price difference.

Out of the money (OTM): When the exercise price of a call option is higher than the actual price at that time, or when the exercise price of a put option is lower than the actual price at that time, the intrinsic value of OTM option is zero.

At the money (ATM): When the strike price of the call option is equal to the
actual price at that time, or when the strike price of the put option is equal
to the actual price at that time, the intrinsic value of the ATM option is zero.

Time Value

The time value of the option decreases as the expiration date approaches, and the closer the expiration date, the faster the time value of the option will decay, and the time value of the options expiration date is zero. Note, time decay is not linear.

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Options vs Futures vs Perpetual Swaps: Low Risk

The main difference between a typical futures and options is that a futures contract does not give the holder the option to exercise the contract. Settlement is a must for future contracts irrespective of the price of the asset. This, therefore, means that the holder’s loss is not limited.

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While for options, the buyer’s downside is only limited to the premium of the option. However, the upside on a position where one has bought an option is unlimited. 

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Depends on the price on exercising, option contract gives investors a “dynamic” leverage compared to perpetual swap, and even better, the buyers have the certainty in their potential losses, the maximum of which would be limited by the amount of premium.

By contrast, perpetual swap breaks everyone’s heart during liquidation when investor lost all their deposit. According to HeYueDi.com, the average liquidation loss of perpetual swap is at the level of 100 million on daily basis, and on high volatility days, the number could heave over 1 billion, and it happened not only in big drop as March 12th but also quite a few bullish rises during the past several months. So, options secure the buyers’ principal and also provide unlimited profit in such cases.

Hedging Purposes

Options are used by seasoned traders to hedge an open position without needing to close it by outlaying a small amount of capital via the premium. All sorts of market players find it convenient and cost-effective to express hedge needs via options. Holders sell covered calls, bullish speculators buy calls, miners buy puts, cash-rich institutional investors sell puts. In several exchanges, there are options on gas fee as well, DeFiers also would find it quite crucial in the fluctuant gas environment.

Varieties

Another important feature of options would be different strategies can be carried out by synthesizing basic call/put options by not only profiting with directional guess but also different kinds of movements of underlying. We only list several most common strategies here, and there are unlimited versions of structured options potentially.

Spreads

Bull/Bear spreads are strategies that attempt to sell away the upside on a call or put to help fund the position. One can still earn if the crypto asset moves in the expected direction, but with limited profit compared to pure buy call/sell put.

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Spreads are implemented by a combination of long and short options at different strikes. When the price of underlying rallies and one will get the defined profit. Although the upside is capped, one has also limited the potential loss on the position by paying a smaller combined premium than buying a call only.

Straddles

Straddles are implemented by buying or selling two different options at the same price, which are effective in profiting with volatility expectation,
irrespective of which direction the price decides to move. They are strategies that are based purely on the volatilities.

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Take the long straddle as above as an example: by purchasing a long call and a long put at the same strike, as long as the price of underlying either rally or fall sharply, the position would be lucrative, while for the opposite, both premiums could be the loss. As we can see during the high volatility period, the straddle is the way to go without taking directional risks.

Butterflies

Combining a straddle with two more options results in “butterflies”, which one can gain a short straddle but protect your downside, or to structure a cheaper long straddle by selling some of the upsides.

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Above elaborate a call butterfly, implemented by selling two calls at K2T, buying a call at K1, and buying another call at K3. So that profit is still be reflected on volatility but be relatively flat until expiry, one, in this case, is also protected from the unlimited downside, while payoff in the middle will be reduced.

As you can see, options can be structured into all kinds of varieties for numerous strategies and purposes. With the rapid progress on crypto market and relatively high volatility, options, once properly applied, would be the ultimate weapon for investors to rule the market.

3.     CeFi vs DeFi

3.1         Why Decentralized Peer-to-Pool Model to Win the Crown Eventually

In my previous article, I have explained the limitation of centralized options exchanges, which are mainly restrained by the participation of professional institutions and the scattered liquidity. The article also told the story of the development of the DeFi version of options trading protocols, from off-chain order book matching to tokenized option contract traded on Uniswap, and eventually, the Peer-to-Pool trading model was functional.

I have faith in the Peer-to-Pool model and believe that it is the right approach for finally igniting the options trading market.

There are three main reasons:

1, Option CEX relies on professional market makers too much. The regulatory processes of blockchain and crypto would take another 3-5 years, so the major force of Wall Street will not be able to enter the arena in the near future, leaving the vacuum of liquidity providing.

2, Other types of DeFi protocols never resolve the issues of scattered liquidity natured by options. Not to mention the Impermanent Loss that AMMers suffered by Uniswap-like DEX.

3, Peer-to-Pool would be proven the key framework almost for any successfully DeFi protocols, which is the widely accepted approach for gathering capital for general usage, here for options, the automated market making. Also, DeFi is more friendly for normal users, more capital and talents are marching into this field for revolutions.

3.2          Asteria to be the Brightest Jewel of the Crown

ASTERIA is recently brought into DeFi as a rising star of decentralized option protocol. After studied carefully of their materials, I believe, it has what it takes to be the top options trading platform of DeFi in the near
future and the potential of attracting all kinds of players both retail and
professionals into their platform.

3.2.1 Why Hedging is Crucial for any Option Market Maker

When we are talking about the limited/capped loss of options, it only refers to the buyer side; while for the opposite position holder, the seller could suffer unlimited damage on their collaterals.

Professionally put, if the option seller, also the market maker or liquidity provider goes “naked”, their positions could be very dangerous for themselves.

It is true in either CeFi or DeFi. In CeFi, market makers are institutional players most of whom selected by the centralized exchanges and are obliged to deposit a big amount of assets as collateral for delivery insurance, which as stated earlier is the key reason CeFi options grew slowly. In DeFi, few protocols that applied the collateral pools are protecting the collective capitals by hedging, such as Hegic or FinNexus.

Let me take a step back to get the basic idea on the theory of Delta Neutral Hedging: The most well-known and fundamental theory about options is the Black-Scholes-Merton model, which won the Nobel Prize in 70s.

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The takeaway of this model for any option market maker or dealers would be they found they can dynamically replicate the risk of an option by hedging their delta exposure to the price movements of the underlying market, throughout time. Usually, we called it risk-neutral probability as the theoretical probability of future outcomes adjusted for risk. That means theoretically market makers would be able to hedge their positions with limited cost and gain the income as the premium from buyers. To accomplish this fixed income like revenue, dynamic hedging is a must.

More academically, there are several factors as Greek letters in the B-S formula, each represents the risk factor for option market makers:

Delta: Measures the change in the options price given the change in the underlying asset’s price.

Theta: The amount of time left until the option expires. More time to expiry yields higher options price.

Gamma: Delta is not static. It changes depending on how in-the-money or how out-of-the-money the option gets. As well, when time gets closer to expiration delta also falls. That change rate in delta is called gamma.

Vega: Tracks what the market is forecasting as the volatility (the standard deviation) in the underlying asset in the time until expiration.  The higher
the volatility in the underlying asset, the more likely the option is expected
to become profitable and therefore becomes more expensive. Implied
Volatility is calculated using all the other “greeks” above and the premium
of the option in the market to reflect the expectations of the underlying
asset’s volatility.

ASTERIA, to implement a comprehensive risk management system for option market makers capital(the shared pool):

Delta Risk Control: through Delta Neutral Strategy, hedging the directional risk exposure of net position.

Liquidity Risk Control: Dynamic quotation of quantity based on shared pool liquidity, to prevent liquidity exhaustion and ensure the stability of market-making capital.

Gamma Risk Control: Option structures and parameters diversification to lower the net position ratio and hedging cost.

Vega Risk Control: Adjust hedging frequency according to the dynamic estimation of underlying assets volatility.

Credit Risk Control: Margin call adoption of exotic options such as Snowball Option and Phoenix Option.

To conclude, Asteria deliver strategies for managing risks to ensure the safety of the shared capital pool of all liquidity providers and apply hedging mechanism which is essential to be a legitimate market maker/seller for options trading.

3.2.2 Why Pricing is Crucial for any Option Market Maker

Pricing an options contract requires deep understanding of the B-S model which includes stochastic theory and different pricing methods, such as the Cox-Ross-Rubinstein formula (binomial Model) and the Monte Carlo method.

The reason any option seller needs to be fair and professional on pricing is that pricing play an important role on hedging mechanism.

ASTERIA, from their white paper, would implement different pricing models, centered by BSM framework for various types of options such as European and American options and Exotic options.

Only with a solid and fair pricing system, one protocol can be legit to perform hedging and attract more buyers into the platform for trading options.

Another key input of pricing would the be underlying pricing feed and Implied Volatility calculations.

All other decentralized option protocols, as far as I know, are using third-party data providers such as Chainlink and skew.com. The nature of third-party and centralized website cannot fundamentally prevent what has been happening in quite large-scale of pricing manipulation in the traditional finance market, which in DeFi, can be carried out even easier.

In traditional finance, sorts of ways for price manipulation such as fake news and circular trading, exercised by big professional option players to disrupt the price and volatility to gain profit.

ASTERIA, for the goal of protecting normal option investors, have strategic partnered with API3, same as a rising star in Oracle services with first-party provider and DAO mechanism, which could largely prevent malicious price feeding and market manipulation:

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Hence, another safeguard is installed by Asteria.

3.2.3 Why Return Rate is Crucial for any Liquidity Pool

The return rate and APY would be THE key metric for any model utilizing a collective liquidity pool. The return of the pool is the main attraction for investors, both retail and big whales to decide whether stake asset for providing liquidity.

From the ranking of TVL of option protocols, we can see most of the relatively successful option platforms have drawn over 10 million in the pool, while the daily trading volumes are only at the level of hundreds of thousands.

That means the premium of the current buy power as the only income other than mining for the liquidity provider cannot hold the regular APY as normal DeFi project were on average at two digits of percentage.

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So basically, without solid income model, option platform will not maintain the TVL once the early batch mining period end and it is happening for Hegic: they lost 30 million recently due to the unsatisfied return rate for liquidity providers.

ASTERIA, applies two levels of dynamic aggregators in their infrastructure: one is on the top of lending protocols, where they invest a part of the capital, by algorithms, into Compound and other similar platforms to receive the interest rate and yield farming income.

Another one is aggregated trading by hedging engine which would dynamically adjust the positions on spot markets, perpetual swaps and options markets.

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With those two aggregators deployed, the platform would dramatically enhance capital efficiency and boost the return rate, building a sustainable business model for long-term prosperity.

3.2.4 Why Layer2 is Crucial for any Options Trading Platform

The booming of DeFi elevated the level of gas fee, which has become the Achilles' heel for any DeFi project for a while. I have personally experienced on several decentralized option protocols, the gas cost was sometimes even higher than the premium for a single share of option, which would definitely be the roadblock for market expansion.

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ASTERIA, have strategic partnered with state-of-the-art Layer2 pioneer Metis protocol to integrated with Optimistic Rollups solution in V2, which would greatly expand the scalability of the system, and reduce the time and cost of option transactions, and to build high-frequency trading foundation for the inevitable outbreak of the options market.

4.     Conclusion

Option market could be the final track of the crypto world to witness exponential growth and writer have the strong feeling it would be explosive in DeFi, especially by comprehensive and professional solutions providers such as Asteria.

It would be quite exciting to look forward to the next development of this protocol.

Reference:

[1] http://skew.com/

[2] https://www.deribit.com/

[3] https://www.kaiko.com/

[4] https://etherscan.io/gastracker

[5] https://api3.org/

[6] https://defipulse.com/

[7] https://explore.duneanalytics.com/dashboard/hegic-v2

[8] https://www.hegic.co/

[9] https://metisdao.org/

[10] https://asteria.finance/

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