How to Choose and Trade DeFi Options

Real World Examples with Bob!

So you’ve decided to start trading options? Or maybe you’ve been trading options but it’s not going how you want it to go. Let’s break down some basics about options and how to choose which options you want to trade on Premia 👇

Calls and Puts: The Basics

Options are derivatives that give the buyer an opportunity to buy or sell the underlying asset at an agreed upon price (the strike price) for a certain amount of time (before the expiration date).

Buying a Call option gives you the right to buy the underlying asset at the strike price.

Buying a Put option gives you the right to sell the underlying asset at the strike price.

Here’s a real-world example to help understand Call options:

Bob runs a hardware store and has lumber. John is planning on building a house next year but he is worried the price of lumber might go up a lot so John goes to Bob’s hardware store and says “I want to lock in the price of lumber today for the house I’m building next year” and Bob says “Sure, you can buy 1000 pieces of lumber from me next year at the current price of $3 but you need to give me an extra $50 and buy the lumber before the end of next year” The 2 men agree and shake hands. John has just purchased a Call option on Bob’s lumber for 1000 pieces with a strike price of $3 and an expiration on December 31, he paid Bob a $50 premium for the option.

Of course, in finance and trading, you don’t need to trot down to the hardware store but now you know how Call options work.

Puts are the opposite of Calls. Puts give you the option to sell at a fixed price. So let’s return to Bob’s hardware store to see what a Put option might look like in real-world terms:

Bob has ordered too much cement mix and he just found out another hardware store is opening that will also sell cement mix so he’s worried the price of cement mix will go down. He goes to his friend Joe and says “will you buy 1000 bags of cement mix from me at $5/bag next year if the price goes down?”, and Joe says “sure but you have to give me $200”. They agree and shake hands. Bob has just purchased a Put option from Joe for 1000 bags of cement with a strike price of $5 and an expiration date of December 31, and he paid Joe a $200 premium for the option.

In trading, a trader would want to purchase a Call option if they’re bullish on the underlying asset going up and they’d want to purchase a Put option if they’re bearish and think the underlying asset will go down. It’s important to note that options give traders the right but not the obligation to execute the trade at the strike price — often traders will choose to close their options prior to expiration rather than exercising them.

The difference between DeFi Options and Traditional Options

Traditional stock options use an order book style option 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.

Premia’s DeFi options on the other hand utilize an AMM similar to how Uniswap works. Liquidity providers deposit assets to earn yield and fees from options 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.

If you’re used to trading traditional options then you’ll find Premia’s DeFi options to be a welcome change.

Here are some of the features that differentiate DeFi options from traditional options:

  • Ability to set custom expiration dates

  • Ability to set custom strike prices

  • Ability to set custom option sizing (not limited to fixed increments of 100 shares like stock options)

  • Permissionless buying/selling

  • Instant liquidity

  • 24/7 option trading

  • Dynamic pricing based on supply and demand

These features make Premia’s DeFi options vastly superior to traditional options, offering traders precision and flexibility in choosing what options they want to buy.

It’s clear that there are a lot of pros to being an option buyer in DeFi options vs traditional options but what for option sellers?

To Be or not to be (a buyer or a seller)

The first thing to understand is that when talking about selling options — sell calls if you have a bearish/neutral outlook and sell puts if you have a bullish/neutral outlook. It’s the opposite of what option buyers look to calls and puts for, this makes sense because the option seller is literally the counterparty and the seller wants the options they sell to expire out-of-the-money so that they can collect the premium without having to exercise the underlying.

In the current implementation of Premia v2, option sellers cannot specify which options their liquidity gets allocated to. Liquidity providers (LPs) deposit in the Premia pools and the Premia system allocates that capital to underwrite options as they are created by option buyers. This is very different from traditional options where the seller dictates the strike and expiration on options. One way to put it would be that in traditional options, the seller calls the shots regarding strike and expiration — but with Premia v2, the buyer calls the shots and decides what the strikes and expirations will be.

Premia v3 (🔜) will bridge the gap between DeFi option buyers and sellers (LPs) by allowing LPs to select specific price ranges that they want to underwrite. Think of it similar to Uniswap v3 where LPs can select the prices they are willing to LP and their capital only gets used when the price is within that range. Premia v3 will work the same way except with option strike price ranges.

Risks of DeFi Options

There are risks in any trading market and options are no different. Various risks exist for DeFi option buyers as well as DeFi options sellers and those risk parameters are different from risks in the traditional options markets.

For DeFi option buyers, the risk profile on Premia’s DeFi options is basically the same as it would be for a traditional option buyer. The primary risk is that the option expires worthless and the trader loses the premium they paid for the option. This means the downside is capped for option buyers — they cannot lose more than the premium paid for the option.

The risk for Premia LPs (the DeFi option sellers) is different than it would be for a traditional option seller. Let’s assume traditional option sellers are selling covered positions, the risk there would be that the options expire in the money and get exercised and they have to either buy or sell the underlying asset in response. All Premia options are always fully collateralized by the liquidity in Premia pools provided by LPs. LPs may experience impermanent loss if their capital gets allocated to a lot of options that expire in-the-money. This impermanent loss can be possibly offset by option premiums paid by buyers as well as liquidity mining rewards.

Have questions about Premia?

If you have any questions about options and the Premia protocol or if you just want to share memes then hop in our Discord and we’d be happy to answer your questions or post some memes with you.

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