Using options to hedge DeFi risks

It is quite funny that in 2021 we still have to beware of crypto markets’ volatility. The recent market-wide selloff is a reminder that traders should never drop their guard even in the face of narratives that seemingly back a new paradigm for example, the entry of institutional investors like Elon Musk and Michael Saylor. Builders and the technology lovers haven’t been spared, since it is difficult to navigate this ecosystem while being decoupled from the price — “Eth is money” is the new money after all. For an industry with many firsts, and not enough past data, dumps are the only consistent theme whatever the market regime. The only positive today is that unlike previous bear markets, there are so many easier opportunities right now to make money that do not involve actual trading. Liquidity mining for instance. What is liquidity mining? In DeFi, attracting liquidity is one of the main product features since the protocols are democratized to individuals and not the reserve of special players like big market makers. One way users can get involved is by sending their tokens to protocols such as lending and borrowing platforms for financial incentives such as earning governance tokens of the protocol, interest and fees proportionately to time and amount of tokens you committed.

Impermanent Loss

When you save your money in DeFi protocols there is a chance at some point in the future the value of the tokens you deposited might be lower than when you deposited them. The larger the difference, the bigger the loss. This is known as impermanent loss. This loss is only realized when you withdraw your tokens, it only becomes permanent then. Certain conditions such as when the market is in a downtrend can worsen this loss, cutting heavily into your capital. It is particularly annoying when you realize that you are net negative after receiving all the financial incentives of using the protocol.

An example of liquidity mining is when you provide liquidity to a decentralized exchange like Uniswap. Stablecoin pools for example WETH/USDT pair on, will suffer less impermanent loss compared to token pools such as WBTC/USDT but they are also less exposed to upside when the market is rallying.

This makes it a difficult choice for users who want to protect themselves against downside risk while they are exposed to upside. Since liquidity mining is not going anywhere soon, we might as well seek ways of protecting ourselves from negative yield. One way to do this is through options.

Options are financial instruments that allow buyers the right but not the obligation to buy or sell assets at a future date at a predetermined strike price. There are two main types of options contracts: puts and calls. When you buy a call you have the right to buy the underlying asset at a predetermined price at or before the expiry date. Conversely, when you buy a put you have the right to sell at a predetermined price at the expiry date. Due to the freedom the option affords them, the buyer of the option pays a premium that is determined by the market conditions. When the sentiment is bullish, calls trade more expensive than puts and vice versa.

One of the main uses of options is to hedge positions. Overall, options achieve this more cheaply futures due to no funding rate and no liquidation risk, as the premium which is the cost of the option is already determined beforehand. Options are much more technical than futures, hence attract more savvy players. In crypto markets they can be used as a leading indicator on market direction even over futures or spot. In addition, options allow traders to bet on volatility and not on the market direction unlike spot and futures trading. Whichever type of trading is easier is subjective, but I feel direction trading is much harder, especially in crypto where while the future outlook might be positive the volatility is hard to stomach.

Average 20/30 Skew(Source: Genesis Volatility)

You do not have to understand options deeply especially if they are not what you frequently trade. What you need is understanding basic option strategies that can give you an informed idea of the market’s outlook into the future. For instance, one telling observation present since the days leading to the recent dump is the high premium of puts over calls. This shows high demand in puts as traders sought insurance in the event the market dipped. These images show the 20/30 Skew which tracks how expensive puts trade vs calls. When the value is very negative, as shown here, sentiment is bearish, and vice versa.

Constant Maturity 20/30 Skew (Source: Genesis Volatility)

Since most liquidity mining protocols require you to lock up your capital in an overcollateralized position, it would be wise to hedge your ETH or BTC from downside. And options can allow you to get the best of both worlds, protecting you from downside while still reaping gains of yield farming.

On-chain Options: delta.theta

In crypto markets, the size of on-chain options protocols are tiny compared to spot dexs. Spot decentralized exchanges like Uniswap are much simpler to design and have had a larger headstart over options protocols. In more established markets such as traditional markets, derivatives volumes are multiples larger than spot volume. This means that there is a lot of room for growth for on-chain options protocols, going by the popularity of dexs.

delta.theta(Source delta.theta website)

Delta.theta is an innovative decentralized options protocol on Binance Smart Chain seeking to make options trading easy for as many users as possible. Considering the explosion of unique cryptoassets, delta.theta can allow owners to hedge downside risk against any asset: synthetic asset, erc20 tokens or even NFTs as long as they can be priced reliably. This is a huge opportunity going forward as the ecosystem grows.

delta.theta terminal(Source: delta.theta website)

Delta.theta smart contracts have been audited by Hacken, and the testnet has been running on BSC for a while now. After the public sale early in June, delta.theta should be launching on Mainnet soon.

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