How do Options work in DeFi?

Options are a common type of financial derivative, meaning that their value is derived from an underlying asset such as a stock, a commodity, a financial index or a currency.

An option contract gives the holder the right, but not the obligation, to buy (call options) or sell (put options) an asset at a fixed price (referred to as the “strike price”) at a specified point in the future. At the time of expiration, the options contract may be exercised or not, depending on the market price of the asset.

Options are useful as a way to manage risk in that, rather than investing directly in an asset that an investor believes will increase in price, they can buy call options on that asset. This permits the investor to profit from the potential increase in the asset’s price, while at the same time retaining the majority of their capital to use for other investments (in effect, leveraging their position).

Someone purchasing a call option is betting on the price of the asset being above the strike price at the time of expiration, thus having the opportunity to buy at a discount compared to the market price. The opposite is true for put options; the holder is speculating that the price of the asset will be below the strike price, thus being able to sell the asset above its market price.

An options “writer”, usually a financial institution such as a bank, offers options contracts at a price (premium), which is set based on the conditions of the option, including market volatility and time to expiration. This risk assessment is a highly sophisticated process to ensure that the writer is able to turn a profit, over time generating more income in premiums than it loses to options exercised. The safest type of option contract is a covered call, in which the writer offers the holder the option to buy assets within the writer’s portfolio.

While widely used in traditional finance, options are vastly underutilised in DeFi. In place of a bank, a smart contract can write options automatically, offering call options on assets staked within a protocol.

An example of options in DeFi is StakeDAO's partnership with Opyn, offering an ETH covered call strategy. This strategy generates yield via the premiums for which it writes weekly call options to market makers. The aim, like any options provider, is that these calls will expire unexercised, i.e. the ETH price is below the strike price, thereby accumulating the premiums each week as yield for depositors. In weeks when ETH is trading above the strike price at expiry and the options are exercised, any losses are mitigated by the fact that the entire vault’s value has appreciated with the increase in the price of ETH. The strategy therefore is able to turn a profit each week, regardless of whether options are exercised or not.

As this is DeFi, however, further yield is earned on the strategy’s underlying ETH deposits, as it is used as collateral on the Opyn platform. This, when combined with the call option premiums, results in a further boost to the APY of the strategy for depositors.

Example

One week, the strategy sells call options for 1000 ETH with a strike price of $4,000, when at the time ETH is trading at $3,150. The premium that buyers pay for the options is 0.7% (in this case, 7 ETH). At time of expiry, ETH is trading at $3,500, and the options are “out-of-the-money.” This week, the strategy has earned 0.7% yield (36% APY).

The next week, the strategy sells call options for 1,007 ETH with a strike price of $4,500, when ETH is trading at $3,500, and receives an additional 7 ETH premium (0.7%). At time of expiry, ETH is trading at $4,700, and the options are “in-the-money”. This week, the strategy needs to pay its counterparties (market makers) with the difference between the settlement price at expiry and the strike price. In this case, it pays 1,007 x (4,700–4,500)/4,700 = 43 ETH (-4.3% return). The total return for the strat during this week is therefore 7–43 = — 36 ETH (-3.6%). However, the user is not at loss during this week, as his position benefitted from the ETH price increase and the premium earned. In USD terms, the strategy value increased from 1,007 x $3,500 = $3,524,500 to (1,007–36) x $4,700 = $4,563,700, representing a 29% increase.