Options give the holder the right, but not obligation, to purchase an underlying asset for a pre-determined price at a specific point in the future. This differs from futures, as there is no obligation.
Options are incredibly versatile instruments, and sophisticated traders can use the wide range of choices to create derivatives that suit a specific purpose. For example, if they hold a range of alt-coins and want to protect against 70% of potential downside, a basket of options can achieve this. The underlying asset, and goal of the basket, can be changed to suit any need!
Put – give the buyer the right, but not obligation, to sell a set amount of an asset at a set price.
Call – give the buyer the right, but not obligation, to buy a set amount of an asset at a set price.
Let’s have a look at a call option example:
Leo buying an ETH call option from Bill:
- Leo pays Bill $200 now, for the right to buy 1 ETH for $3,000 in 1 months’ time.
- Leo wouldn’t be forced to buy it (unlike futures), so if the price goes down, he only loses the premium.
- If Leo wants to buy it, Bill must sell it to him at the set price. If ETH goes up to $5,000, Leo has made a $1,800 profit.
Now, if Leo was buying a put option from Bill:
- Leo pays Bill $200 now, for the right to sell Bill 1 ETH for $3,000 in 1 months’ time.
- Leo wouldn’t be forced to sell it (unlike futures), so if the price goes up, he only loses the premium.
- If Leo wants to buy it, Bill must buy it from him at the set price. If ETH goes down to $1,000, Leo has made a $1,800 profit (as he can sell his ETH to bill for $3,000, then buy a replacement ETH on the spot market for $1,000).
Selling Options
In the examples above, Leo is the buyer of a call and put option, Bill is the seller.
Selling options is much more complex than buying them, as it requires specialist knowledge to select strike prices, expiration dates, and many more complex instruments that are out of the scope of this report (such as the options Greeks: Delta and Gamma for example).
In DeFi, things that have previously been impossible are routinely being done. One such thing allows users to benefit from the returns of options selling, simply by depositing their assets into a pool. Enter, DeFi Options Vaults.
DeFi Options Vaults (DOVs)
DOVs make it possible for anyone to benefit from the high, sustainable yield you can get from selling options. Users simply deposit into the pool, which the protocol uses as collateral to sell options, either through auctions or directly on platforms such as PsyOptions.
Katana is an example of a DOV. It advertises projected Annual Percentage Yields (APYs) between 20-60%, with most falling between 20-30%. It is important to note that these returns are not guaranteed, and there is a risk of loss. Read the risks section later in this report.
There are two types of options that most DOVs sell:
Covered Calls
Sells a call option, giving the buyer the right to buy the underlying asset at a set point in the future, for a set price (the strike price); while simultaneously hedging by buying spot to cover the risk of selling the option (hence the name).
The seller hopes the price will remain below the strike price. As you can see in the chart above, once the asset goes above the strike price, returns go down.
This would mean the buyer doesn’t use (exercise) the option, and buy the asset off the seller. The seller then keeps the asset, and the premium (the amount the buyer paid for the right).
The optimal situation for the seller: the assert price rises to just below the strike price, as they will benefit from a modest rise in the asset price, and keep the premium.
If the price of the asset falls, the seller will lose USD value, as they are holding the asset as collateral. However, they earn the premium. If they would be holding the asset anyway, then they have turned a profit.
Selling covered calls is a great strategy for times of low volatility, or bear markets if you would be holding the asset anyway.
Cash Secured Puts
Sells a put option, while keeping cash ready to buy the underlying at the options strike price (the price you have agreed to buy the underlying from the options buyer).
The profit for a cash secured put is the premium the buyer paid. As long as the strike price is not hit, the seller earns the profit. After the strike price is hit, price rises have no effect on the payoff.
Comparing their payoff side by side, you see how a covered call strategy is profitable when prices remain the same or go down. A cash-secured put strategy is profitable when prices remain the same or go up.
Note, this does come with risks.
Deposits into DOVs can suffer losses.
Generally, they sell far out-of-the-money options, for example, a call option with a $110 strike price when the price is $80.
If the price jumps to $120 before expiry, the buyer would exercise the options and buy the asset, which would result in a loss of $10 for the seller (minus the premium earned) when compared to buying and holding the asset.
Using a similar example for a put, the current asset price is $80, and you sell a put option with a strike price of $60. If the price falls to $50 before the expiry, the buyer would exercise the option and sell the asset to you for $50, resulting in a $10 loss (minus the premium).
As puts are cash-secured, the seller locks up the relevant amount of USD, so the loss is a direct USD loss. For covered calls, the loss is when compared to holding the asset, as that is what you are locking up.
