What Are Options?

Integrating options markets into the decentralized finance (DeFi) ecosystem marks a pivotal development in cryptocurrency trading, blending traditional financial instruments with cutting-edge blockchain technology. Despite its potential, weaving options trading into DeFi is fraught with complexities. This exploration sheds light on these intricacies, unraveling the challenges that investors and developers face and proposing viable solutions.

At their core, options are contractual agreements offering the buyer the right—but not the obligation—to buy (via a call option) or sell (via a put option) a specific asset at a predetermined price.

These contracts are characterized by:

Premium: The cost incurred to acquire the option contract
Type: Distinguishes between a call (buy) and a put (sell) option
Asset Specifications: Defines the asset and its quantity covered by the contract, which can vary from cryptocurrencies like Bitcoin to traditional commodities and stocks
Strike Price: The pre-agreed price for the transaction of the underlying asset, a critical factor in options trading
Expiration Date: The deadline by which the option must be exercised or forfeited
Exercise and Settlement Rules: The regulatory guidelines governing the execution and finalization of the options

Finally, central to understanding options trading is the concept of "moneyness," which assesses an option's profitability by comparing the market price of the underlying asset to the option's strike price. This metric is crucial for determining whether an option is "in the money" (profitable), "out of the money" (not profitable), or "at the money" (neutral), guiding traders in their decision-making process.

The Greeks

To best understand options, it is important to grasp the underlying factors influencing option pricing and strategy. This is where "The Greeks"—a set of mathematical measures—come into play, offering traders and developers a sophisticated lens through which to analyze and predict the behavior of options in a fluctuating market. The Greeks, named after the letters of the Greek alphabet, provide insights into the sensitivity of option prices to various market factors, including price movements of the underlying asset, time decay, and volatility.

Understanding these metrics is crucial for anyone navigating the DeFi options landscape effectively. They not only illuminate the potential risks and rewards associated with different options strategies but also offer a framework for making informed decisions in a market known for its complexity and dynamism. Each Greek addresses a specific risk aspect and can be used to construct strategies that align with an investor's market outlook and risk tolerance.

This report will cover four - Delta, Gamma, Theta, and Vega.

Delta: The Essence of Rate of Change in Options

Delta signifies the rate of change in the option's price relative to the underlying asset's price movement. For instance, an ATM call option typically has a delta of 0.5, implying that for a $1 increase in the asset's value, the option's premium rises by $0.50.

Conversely, an ATM put option has a delta of -0.5. For options with low deltas, such as far OTM call options (e.g., delta = 0.10), the relative gain in value is minimal compared to the underlying asset's gains.

Gamma: Understanding the Acceleration of Delta

Gamma measures the rate of change of delta itself, analogous to how acceleration relates to velocity in physics. It reflects the volatility of delta for an option. A higher gamma value means Delta will likely have a greater response to changes in the underlying asset price, while a lower gamma value means the opposite. Typically, gamma peaks near the option's strike price, where the uncertainty of the option expiring in or out of the money is greatest.

Theta: The Time Decay Factor

Theta represents the rate an option’s extrinsic value decreases over time, also known as time decay. Extrinsic value is a product of the time remaining for the option and its implied volatility.

In effect, it is the theoretical profitability of the option. Intrinsic value is the difference between the asset and the strike price or the value of the option if exercised. As time passes, the underlying asset has less time for the price to change and intrinsic value to increase, and the extrinsic value decreases. The value of theta, or the rate the extrinsic value decreases, is generally low for long-term options and high for short-term options.

Vega: Sensitivity to Volatility

Vega measures how changes in implied volatility affect the value of an option. The value of an option on a volatile asset is generally higher than that on an asset with low volatility. Implied volatility serves as a forward-looking indicator, reflecting market expectations about the potential for large changes in an asset's price. Higher implied volatility compared to historical volatility can signal market anticipation of substantial changes to the asset’s price.

Basics of Options

Call and Put Options

Investors use call options as a strategic bet on the appreciation of an asset’s value. Conversely, put options are employed when anticipating a decline in an asset's value. A crucial aspect of options is their derivative nature, meaning the investor does not own the underlying asset but rather a contract stipulating terms for acquiring or disposing of the asset at a specified price.

The option owner has the right but not an obligation to exercise the option. This protects the option owner by limiting potential losses, as the owner will not execute the option if it is not profitable.

For instance, consider a scenario where an investor purchases 10 BTC call options with a strike price of $55,000, set to expire on December 31st. This contract grants the investor the right to acquire 10 BTC for $550,000 any time before the year's end, regardless of the actual price of BTC.

If BTC decreases in value from $55,000 to $54,000, someone who owns 10 BTC would incur a loss of $10,000, while someone who owns the example contract would not be directly affected by the change in price. The only loss for the option owner in this instance would be the cost of the premium.

Importantly, this is a characteristic of the American-style option, which allows for exercise at any point until expiration. In contrast, the European-style option restricts the exercise to the expiration date alone. In this example, a European-style option would only be able to be exercised on December 31st.

Selling Options

Selling options can generate revenue through premiums. Depending on the type of option sold, the seller may have to purchase the underlying asset or update their cash balance to cover their position if the option is at risk of expiring ITM.

Hedging Options

At its core, hedging is a risk management strategy employed to offset potential losses in investments. It involves balancing the inherent risks of market volatility with the potential for profit.

It can be thought of as a type of insurance policy where the cost of protection is weighed against the likelihood of an adverse event. This balance is particularly critical with smaller-cap DeFi and crypto assets, where the absence of centralized control combined with much smaller valuations generates additional layers of complexity and risk.

There are many different strategies for hedging options. Some key possibilities include:

Longer Dated Options: Opting for options with longer expiration periods may seem like a prudent choice for those seeking to hedge against long-term market uncertainties. However, this increased timeframe introduces a higher level of unpredictability, inflating the cost of hedging. These options are priced higher, reflecting the greater risk borne by the option writer over a longer period.
ATM Options: At-the-money (ATM) options occupy a critical threshold where the strike price and the market price of the underlying asset are in close proximity. This delicate position makes ATM options highly sensitive to even minor price movements, necessitating more frequent adjustments to the hedge to maintain its effectiveness. The precision required in managing ATM options underscores their dynamic nature and the meticulous attention needed to leverage them effectively.
OTM Options: Options that are out of the money (OTM) represent a different strategic posture. Given their lower probability of becoming profitable (expiring in the money), OTM options require less frequent hedging adjustments. This characteristic makes them potentially less costly in terms of hedging, but it also reflects the lower likelihood of a payout.
Options in Volatile Markets: The challenge of hedging escalates in volatile markets. Price swings can be abrupt and significant, demanding constant vigilance and rapid adjustments to hedge positions. The increased frequency of these adjustments directly impacts hedging costs, making volatility a key driver of the premium. For traders and investors, understanding and anticipating market volatility is crucial in formulating an effective hedging strategy.

In essence, an options contract compels the writer to engage in buying or selling the underlying asset as a hedge. The costs incurred in maintaining this hedge are directly reflected in the option's premium. Thus, the higher the hedging expenses, the greater the premium an investor pays for the optionality provided by the contract.

The Double Coincidence of Wants in Options Trading

In cryptocurrency trading, achieving a 'double coincidence of wants' is significantly more challenging in options markets than in spot or futures markets (referred to as Delta 1 products because the underlying asset value and the asset price generally move close to a 1:1 ratio). In spot and futures trading, matching buyers and sellers around a current market price is relatively straightforward due to the volume of participants. However, in options trading, encompassing both puts and calls for each strike price and expiration date presents a greater challenge.

Options, unlike Delta 1 products, are not perpetual, and their value is heavily influenced by the time remaining until expiration. The total number of options is split among a range of expiration dates and strike prices, fragmenting liquidity.

For instance, Bitcoin options might have contracts at every $1,000 interval from $25,000 to $33,000, with expiration dates spanning weeks, months, and quarters. This makes it harder to match buyers and sellers in the options market. Even if there are a large number of total options, buyers and sellers can be interested in vastly different contracts for the same asset.

To complete a transaction, there needs to be an agreement between a buyer and seller on the premium, expiration date, strike price, type of option, and the quantity of the underlying asset under the contract. Compare this to Delta 1 products, which only require a buyer and seller to agree on a price.

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