In traditional CeFi, or centralised finance, options are as lucrative as they are terrifying. Powered by the energy of speculation alone, options trading rewards traders whose risk appetite hungers for more than buy-and-hold strategies. Regarded as a more advanced derivative, options trading often comes with a disclaimer or test to warn off those without such insatiable risk appetites.
DeFi adds another layer of complexity to options but cryptocurrency’s unmatched returns, coupled with the extremely profitable nature of options, make DeFi options an area worth considering for every level of investor.
What are options?
Here’s an unpopular opinion: options aren’t that difficult to understand. Options are contracts that give its owner the right but not the obligation to either buy or sell an asset at an agreed-upon price by an agreed-upon time. An option buyer can choose to exercise the option at the time of expiry and the option seller (AKA the option writer) is obliged to fulfil it.
There are only two types of options: calls and puts. A buyer of a call option believes the price of the asset will increase, whilst the buyer of a put option believes the price will fall.
The strike price is simply the price at which the asset needs to reach for the buyer to exercise the option. For the buyer to profit from the contract, the price needs to not only reach the strike price but also edge high enough to cover the premium charged to make the transaction.
If the asset fails to reach the price by a given date, the option will expire worthless and the buyer won’t exercise the option whilst the seller will take off with the premium charges. It’s a zero-sum game between buyer and seller, with one party positioned to profit at the other’s expense.
Although there are numerous options strategies constantly at play, we’ll only need to concern ourselves with covered calls and puts for now. A bullish investor can use options to have his cake and eat it. If the investor expects the asset to rise in time, they would be well-positioned to buy the underlying asset. However, if the investor forecasts short-term volatility, said investor could sell call options against the asset as a hedge.
Any downward movement in the asset’s price is offset by the option writer’s premiums earned by selling the option. Essentially, a decline in the asset’s price provides additional money in the bank as the investor holds on to the asset for the long term.
If the asset’s price reaches the strike price or higher, the writer is forced to sell the asset at that price. In this case, the writer still profits because their underlying asset has ultimately still appreciated.
The opposite applies for covered put plays.
Trading crypto shares similar mechanisms with trading stocks, and the same is true for derivative instruments. The concept of options trading – i.e., betting on a particular price by a particular date – is easily applied to crypto.
QCP co-founder Darius Sit explains that the “typical retail investor looking for high yields does the covered calls/covered puts strategy” whilst the speculative trader “buys options”. His statement rings true for both crypto and equity investors.
The buck doesn’t stop with retail investors either.
“Institutions come into the mix of both”, Sit continued. “They’re either hedging or taking speculative positions. Just today we had our biggest ever request for Bitcoin call options: 10,000 Bitcoin notional. I only ever saw that kind of size in traditional finance but now we are seeing it in crypto as well”.
As crypto’s presence in the financial space increases, institutions are taking notice of the returns offered by the digital currency, and are incorporating them into traditional financial instruments.
DeFi Option Vaults (DOVs)
We’ve drawn your attention particularly to covered calls and puts because they’re the primary strategies executed by DOVs, for now at least. Among DeFi instruments, DOVs offer the highest base yield, with an average of 15-50%. This isn’t even factoring in tokens rewarded to users and staking the token. DOVs offer users all three yield opportunities; CeFi options only offer one.
This all may sound complex but DOVs have made their way into the crypto limelight for their simplicity. Instead of investors calculating the strike prices, premiums and dates to position sell their covered calls, DOVs carry out the leg work for them.
Just like option traders, the DOV holds a long position in the token and sells call options of the same token. The same mechanisms as traditional options are then in play, and the same risks apply.
More Than An Instrument
The concept of DOVs is nothing new. In fact, they’re simply taking a tried and tested traditional financial instrument and applying it to crypto currency. However, for the crypto market itself, DOVs are yet another step towards fine-tuning cryptocurrency’s democratisation.
Yields earned by DeFi coins have largely come from token rewards and staking tokens. In a rather vicious circle, yields depend on token price inflation but are equally victims of said inflation. Opportunistic DeFi yield seekers capitalise on rising token prices but if newcomers are deterred by inflated prices and interest in the token falls, yields will flatten.
Yields from DOVs are not reliant on token rewards but instead ride crypto’s turbulent volatility wave. Just like CeFI options, returns are earned simply from option premiums. The mechanism offers far more sustainable yields, which could help to scale DeFi, especially considering crypto volatility is 10-20 times that of CeFi.
DOVs also encourage traders to consider altcoins. According to QCP, “DOVs have become the largest trading venue for altcoins with sizable vaults in ALGO, LUNA, AAVE, AVAX and more in the pipeline”.
Covered calls and puts are regarded as one of the least risky strategies in traditional finance. When applied to the crypto space, investors are far more likely to dabble in volatile altcoins when their downside risk is minimised.
For the crypto space, DOVs democratize instruments that were originally reserved for traditional finance, whilst beating them at their own game.
We’ll save our more in-depth review of DOV operators for another article, but here are the most notable:
Perhaps the most exciting aspect of DOVs is that they’re still in their nascency. By only currently offering covered calls and puts, DOVs have barely scraped the tip of the iceberg in terms of options strategies. Riskier option plays that result in more alluring rewards exist in traditional finance, and fans of DOVs are waiting with anticipation for them to be brought over.
Additionally, DOVs level the playing field for investors. Whilst option trading in traditional finance is usually reserved for the more high-brow investor, DOVs are accessible for all types of investors. It’s truly a step towards democratising finance, and the future of DOVs has incredible potential.
The beauty of DOVs lies in their simplicity and how they do all the work for you. However, cutting out the legwork for the investor has resulted in a lack of transparency. DOV users are required to trust the vault’s covered call strategy without fully understanding the mechanics of each vault.
Without knowing how or why these DOVs are choosing certain price strategies, are we relinquishing power to them? If so, will DOVs ironically become a source of centralised power over our digital assets? It’s still early to tell, and perhaps DOV operators will offer more transparency in time to come, but for now, we’re as excited as we are concerned.