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DeFi 102: On-chain Options and Trading

By Michael @ CryptoEQ | CryptoEQ | 22 Apr 2024


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What Are Options?

The integration of 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 that influence 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 looking to navigate 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 aspect of risk 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 reaches its peak 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.

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Michael @ CryptoEQ
Michael @ CryptoEQ

I am a Co-Founder and Lead Analyst at CryptoEQ. Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.


CryptoEQ
CryptoEQ

Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.

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