DeFi Options 101

Teach me how to Hedge!?

If you want to get started trading DeFi options but don’t know where to begin then this article is for you!

We will dive into option basics, how Premia works and the difference between traditional options and Premia’s DeFi options.

Options Basics

If you’re starting from “zero knowledge” about options then read What are Options article first. Basically, options allow traders to buy or sell assets at a fixed price, called strike price, for a certain period of time, also known as before the expiration date, by paying a small fee, called the premium.

The most common reason for using options is to hedge against their holdings or increase leverage. As with other forms of trading, volatility is your friend. Ideally, the underlying asset moves past your strike price so that your option is in the money. Let’s talk about these use cases for options.

Hedging

The main goal of hedging is limiting the risks of an asset or a portfolio. When hedging, traders buy one instrument and subsequently sell the other to offset the risk or pair one instrument with another. Hedging helps traders to protect their active trading positions from making big losses in case of adverse market movements.

Let’s say an investor is holding 10 ETH but is expecting a short-term decrease in price. That investor can hedge their spot holdings by purchasing a Put option covering 10 ETH with a strike near the current price, let’s say with an expiration 2 weeks from now. In the next 2 weeks if ETH goes down more than the premium paid for the option then the investor can collect the difference between the strike price and the current price.

In practice it looks like this:

A user (let’s call him Joe) buys 10 ETH spot but then he thinks ETH might go down in the short term so he goes to the Premia Option dashboard and purchases a Put option expiring in 2 weeks with a strike price where he paid for his ETH (let’s say $1200). He pays a premium for the option, in this case it’s $1217 and in the following 2 weeks ETH performs terribly, plummeting 30% to $800 but with this option Joe collects $2,788 so instead of facing a loss of $4000 in spot value he only loses the premium he paid for the option. Joe protected himself against the downside risk using Put options.

Increasing Leverage

Options can be used to increase leverage and take advantage of price movements. Since options prices can be cheaper than the actual asset prices, traders can control a larger position in options compared with owning the underlying stock.

Let’s say Joe buys that 10 ETH at $1200 but this time he is bullish and he thinks ETH will go up in the short term. He can increase his exposure by buying a Call option.

Here’s what that might look like:

Joe has 10 ETH in spot holdings but wants twice as much exposure for the next 2 weeks as he expects ETH to go up. He goes to the Premia Option dashboard and purchases a Call option with a strike price of $1200 and an expiration 2 weeks away, he pays a premium of 0.5374 ETH ($629) for the option. Joe is right, ETH goes up to $1500 and he’s able to exercise his option and collect $2319 from the option. The Call option enabled him to have more exposure for the upside.

If you have any questions about options basics, feel free to ask them in the Premia Discord server. Our team and the option gurus of the Premia community would be happy to answer your questions.

What’s unique about Premia options?

If you’ve traded traditional stock options then you’re probably used to an order book style options market where users place bids and asks with a spread between the two. With order book options you can either market buy/sell or wait for your bids/asks to be filled.

On the contrary, Premia’s option protocol utilizes an AMM similar to how Uniswap works. Liquidity providers deposit assets to earn yield and fees from option traders. This peer-to-pool protocol design allows option buyers and sellers instant liquidity, users are able to buy and sell options anytime permissionlessly and without waiting for bids/asks to be filled.

DeFi users are just as decentralized as the DeFi protocols and this permissionless buying/selling is what sets Premia apart. It allows users to operate globally, any time of day, with the most flexibility of any DeFi option protocol.

With Premia, option buyers are able to set custom expiration dates and strike prices. This flexibility is in stark contrast to traditional stock options where market makers determine both the strike prices and the expiration dates. Premia’s architecture puts the power in the hands of the users and allows them to make their custom options with pinpoint precision. Option sizing is also determined by the user, this is another huge difference between Premia’s DeFi options and traditional options which are sold in lots (usually 1 option = 100 shares).

The granular flexibility of Premia’s options protocol means a user can go to Premia and decide “I want an option on 4.69 ETH to be above $1333.62 in 17 days”, then input that option and buy it within minutes.

If you’d like to learn more about Premia, you can check out our Intro to Premia article.

Have questions about Premia?

Hope you enjoyed learning about what makes Premia special and different! If you have any questions about the Premia protocol or options in general, shoot us a question in Discord and we’d be happy to chat about it.

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