Building On-Chain Options and DOVs
This high-level guide outlines the common design variations of on-chain options and how they use oracles in their pricing and settlement.
What are Decentralized Options?
Decentralized options have gained significant popularity within the decentralized finance ecosystem. Options grant traders the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, or strike price, within a specified timeframe. This flexibility allows traders to explore various strategies based on their market outlook.
Decentralized Options in Practice
Options are popular instruments because they enable traders to gain exposure to the price volatility of the asset and express directional views on price movements. Decentralized options typically execute the option creation and settlement process on-chain.
The recent popularity of decentralized options emerged from their ability to offer customization for traders with varying risk profiles, enabling them to tailor positions to specific strategies. Traders can adjust parameters such as strike prices and expiration dates and combine multiple options or derivatives to execute an options strategy. Traders typically use options to achieve the following:
Risk Management
Options can act as insurance against adverse price movements. Participants can use put options to protect their holdings from significant losses if the market goes down.
Leveraged Positions
Options allow participants to gain leveraged exposure to an asset's price movement without needing to put up the full value of the asset as collateral.
Income Generation
Selling covered call options can generate income for participants who hold the underlying asset. They earn premiums from traders purchasing the options.
Speculation
Options enable participants to speculate on price movements without actually owning the underlying asset. They can profit from price increases (call options) or decreases (put options).
Blockchain oracles play a crucial role in the price determination of on-chain options and the settlement of payoff outcomes.
You can start building decentralized, on-chain options and consume oracle price updates immediately with Pyth Price Feeds.
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Decentralized Options How do they Work?
The essential elements of options pricing and their basic mechanisms are outlined below.
Call Options
Call options grant the holder the right (but not the obligation) to buy an asset at a predetermined price (strike) before a specified date (expiration). As the asset's price rises above the strike, the call option becomes more valuable.
Put Options
Put options offer the holder the right (but not the obligation) to sell an asset at a predetermined price (strike) before a specified date (expiration). As the asset's price falls below the strike, the put option gains value.
Underlying
The underlying asset refers to the asset on which the option derives its value. It can be a stock, cryptocurrency, commodity, or any other tradable asset. The price movements and volatility of the underlying asset directly impact the value of the option.
Strike Price
Strike price (or exercise price) is a predetermined price at which the underlying asset can be bought or sold when exercising the option. It plays a significant role in determining the potential profitability of an option contract.
Expiry
The expiry date represents the date on which the option contract expires. It is the last day on which the option can be exercised. Options with longer expiration periods tend to have higher premiums due to the extended time value.
Intrinsic Value
The intrinsic value of an option is the difference between the current price of the underlying asset and the strike price. For a call option, the intrinsic value is the positive difference between the underlying asset price and the strike price, while for a put option, it is the positive difference between the strike price and the underlying asset price.
An option is considered “in-the-money” when the current price of the underlying asset is favorable for the option holder. The option is “out-of-the-money” or “at-the-money” when the current price is not favorable for the holder or equal to the strike price.
Extrinsic Value
The extrinsic value of an option is the difference between its premium and its intrinsic value. Extrinsic value is also known as time value, as it represents the additional value of the option beyond its intrinsic value and accounts for factors such as time until expiration and market volatility. It reflects the probability that the option will increase in value before expiration.
The Greeks
Option prices are influenced by the underlying's price, strike price, time to expiry, market volatility, and a number of other factors known as “The Greeks.”
Delta
Measures how much an option's price changes with a $1 change in the underlying asset.
Gamma
Reflects the rate of change of an option's delta.
Theta
Gauges how much an option's value decreases with each passing day.
Vega
Assesses an option's sensitivity to changes in market volatility.
Rho
Estimates an option's sensitivity to changes in interest rates.
Options pricing is dynamic and subject to market forces, including changes in the underlying asset price, implied volatility, and interest rates. As a result, option prices can fluctuate throughout the life of the option contract.
At a meta-level, options pricing can be influenced by various mathematical models that other traders are following, the most commonly used being the Black-Scholes model. This model takes into account factors such as the underlying asset price, strike price, time to expiration, volatility, risk-free interest rate, and dividends (if applicable) to calculate the theoretical value of the option.
Decentralized Options Designs
On-chain options come in various types depending on how you want to handle order matching, liquidity provisioning, and the range of options trading preferences and strategies you want to provide users.
Decentralized Options Vaults (DOVs)
Decentralized option vaults are a specific type of decentralized options protocol that allows users to interact with predefined options strategies and access pools of liquidity. These vaults automate the execution of options strategies, providing users with predefined risk profiles and investment opportunities.
Smart contracts underpinning the DOVs streamline the execution of options strategies, eliminating the need for manual intervention and enhancing operational efficiency. By interacting with DOVs, users can conveniently access predefined options strategies that align with their risk preferences and investment objectives, saving time and effort in crafting custom strategies.
DOVs also provide users with the advantages of liquidity pooling. By consolidating liquidity from various participants into these vaults, DOVs offer enhanced liquidity and competitive pricing for options trading. This pooling mechanism ensures that traders can execute their options transactions efficiently, even during periods of high demand or market volatility.
AMM-Based Options
AMM-based options trading involves utilizing the liquidity provided by AMM pools, where the prices are determined algorithmically based on the pool's liquidity and the options' parameters. Traders can interact with the AMM pools to trade options by providing liquidity or executing trades against the pool's available liquidity.
The algorithmic pricing mechanism of AMM pools considers factors such as the pool's liquidity, the strike prices, expiration dates, and volatility to determine fair and competitive options prices. This automated process eliminates the need for order book matching and centralizes liquidity within the AMM pools, simplifying the trading experience for smart contract developers and facilitating seamless execution of options trades.
Order Book-Based Options
The more traditional way of trading options, similar to traditional finance, utilize order books for price discovery. These platforms provide users with the flexibility to create and customize their own options contracts, set strike prices, expiration dates, and other parameters. Traders can interact with the order book to place and match buy and sell orders for options contracts.
Within order book-based options platforms, users have the freedom to set strike prices, choose expiration dates, define various contract parameters, and ultimately design options contracts that suit their unique requirements.
Peer-to-Peer (P2P) Options
Peer-to-Peer on-chain options enable direct interaction between option buyers and sellers without an intermediary. Smart contracts facilitate the creation and settlement of option contracts, eliminating the need for centralized order matching. P2P options offer greater privacy and flexibility, allowing participants to negotiate terms and conditions directly.
Over-the-Counter (OTC) Options
OTC options are customized on-chain options tailored to specific traders' needs, negotiated and executed directly between the parties. Smart contracts would facilitate the creation and settlement of OTC options, providing a decentralized and secure environment for private trading.
Types of Options
Options encompass various types with differences in method of settlement and freedom to exercise. Some categories are unique to on-chain trading.
American-style options can be exercised at any time before the expiration date, providing flexibility to traders.
European-style options can only be exercised at the expiration date itself, offering a standardized approach.
Asian-style options calculate the payoff based on the average price of the underlying asset over a specific period. These options can be useful in volatile markets.
Binary options are a type of on-chain option with a fixed payout determined at the time of contract creation. The option either pays out a predefined amount if the underlying asset meets a specific condition (e.g. above/below a certain price) at expiration, or it expires worthless.
Perpetual options combine the features of perpetual futures contracts and options. These options do not have an expiration date but allow traders to exercise them at any time, offering exposure to price movements while allowing more flexibility in timing.
Physically settled options involve the actual delivery of the underlying asset upon exercise. If a trader exercises a physically settled call option, they receive the underlying asset at the predetermined strike price. Similarly, when exercising a physically settled put option, the trader delivers the underlying asset and receives the strike price in return. Physically settled options are particularly suitable for traders seeking direct ownership or exposure to the underlying asset.
Cash settled options, also known as index options, do not involve the physical delivery of the underlying asset upon exercise. Instead, the settlement is based on the difference between the underlying asset's price and the strike price. If the option is in-the-money at expiration, the trader receives a cash payment representing the option's intrinsic value. Cash settled options are commonly used when trading options on indices, where physical delivery may not be practical or necessary.
How Decentralized Options Use Oracles
This section outlines how on-chain options utilize oracles to access real-world data for pricing and settling options on the blockchain.
Pricing Options
Access to oracle prices ensures that an option's price accurately reflects the real-time value of the underlying asset. When a user creates a new option contract, the smart contract would fetch the current asset price from the oracle. This price becomes the reference point for determining the option's strike price and the potential profit or loss at expiration.
As market conditions change, the oracle continuously updates the asset price, allowing the option contract's price to adjust accordingly. This dynamic pricing mechanism ensures that the on-chain options remain aligned with the rapidly changing market conditions, providing a fair, transparent trading environment for participants.
Financial oracles like Pyth can publish a secure and verified price resulting from an aggregate of real-time inputs by exchanges and liquidity pools.
Settling Options
At option expiration, oracles play a critical role in the automatic settlement process of on-chain options. As the expiration date approaches, the smart contract relies on the oracle to supply the final asset price. This price becomes the basis for determining the option's profitability and whether it is in-the-money or out-of-the-money.
If the final asset price is favorable and the option is in-the-money, the smart contract automatically executes the settlement, allowing the option holder to exercise their right to buy or sell the underlying asset at the predetermined strike price. Conversely, if the option is out-of-the-money at expiration, the smart contract automatically cancels the option, and the option holder does not exercise their right to buy or sell the asset.
By relying on oracles for the settlement process, on-chain options eliminate the need for manual intervention and ensure a trustless, efficient execution of contracts. Oracles like Pyth specialize in low-latency prices aggregated from multiple exchanges and liquidity venues to achieve a price output reflective of the overall market.
Pyth is the only oracle which provides confidence intervals, or confidence bands around the reported price which reflect the level of price divergence and volatility across the markets. A wider confidence band (e.g. BTC/USD at $30,000 ± $100 instead of ± $10) indicates greater divergence or “uncertainty” between venues. Options platforms can use this confidence data to inform their risk management.
Options Glossary
This glossary section defines the most common terms in the on-chain options space.
At-The-Money (ATM)
Refers to an on-chain option with a strike price equal to the current market price of the underlying asset.
American-Style Options
On-chain options that allow the option holder to exercise the option at any time before or on the expiration date.
Binary Options
On-chain options with a fixed payout determined at contract creation, depending on whether the predefined condition is met at expiration.
Call Option
An on-chain option that gives the holder the right to buy the underlying asset at the predetermined strike price on or before the expiration date.
Decentralized Option Vaults (DOVs)
Automated market makers designed for on-chain options. They pool liquidity and use smart contracts to facilitate option trading without the need for centralized intermediaries.
European-Style Options
On-chain options that only allow exercise at the expiration date and not before.
Expiration Date
The date on which the on-chain option contract expires, after which the option is no longer valid.
In-The-Money (ITM)
Refers to an on-chain option that would be profitable if exercised immediately. For a call option, it means the current market price is above the strike price. For a put option, it means the current market price is below the strike price.
Liquidity Pool
A pool of funds locked in a smart contract to provide liquidity for trading on-chain options.
Mark Price
The reference price used to calculate profit and loss (PnL) and determine liquidation triggers in perpetual futures contracts.
Out-of-The-Money (OTM)
Refers to an on-chain option that would not be profitable if exercised immediately. For a call option, it means the current market price is below the strike price. For a put option, it means the current market price is above the strike price.
Over-the-Counter (OTC) Options
Customized on-chain options negotiated and executed directly between two parties outside traditional exchanges.
Peer-to-Peer (P2P) Options
On-chain options that enable direct interaction between option buyers and sellers without the involvement of an intermediary.
Put Option
An on-chain option that gives the holder the right to sell the underlying asset at the predetermined strike price on or before the expiration date.
Strike Price
The fixed price at which the option holder can buy (call option) or sell (put option) the underlying asset when exercising the option.
Starting with the Greeks
Options Greeks are a set of risk indicators used to measure the sensitivity of on-chain options to various factors influencing their price and performance. Understanding the Greeks is essential for on-chain options traders and developers as it helps in formulating effective trading strategies and managing risk.
First Order
Delta: measures the sensitivity of the option price to changes in the underlying asset's price.
Vega: measures the sensitivity of the option price to changes in implied volatility.
Theta: quantifies the rate at which the option's time value erodes over time.
Rho: indicates the sensitivity of the option price to changes in interest rates.
Second Order
Gamma: represents the rate at which the delta of an option changes in response to changes in the underlying asset's price.
Charm: measures the rate at which the delta of an option changes as the time to expiration approaches.
Vanna: measures the sensitivity of the delta to changes in implied volatility.
Vera: measures the sensitivity of the vega to changes in implied volatility.
Veta: quantifies the rate at which the vega changes as the time to expiration approaches.
Vomma: measures the sensitivity of vega to changes in implied volatility.
Third Order
Color: captures the rate of change of gamma as the underlying asset's price changes.
Speed: quantifies the rate of change of the gamma.
Ultima: measures the sensitivity of vomma to changes in implied volatility.
Zomma: quantifies the rate of change of gamma with respect to changes in implied volatility.
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