Using options to hedge DeFi risks

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.

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.

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

Hedging Liquidity positions with Options

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 terminal(Source: delta.theta website)

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