*Disclosure: The contents of this guide are purely for educational purposes and should not be construed as financial advice. Before investing in options, we strongly advise readers to understand more about options and its risks.*

#### **Goal**

With this guide, readers should have a clearer understanding of what options are, the cryptocurrency options market, the various DeFi option protocols, and how they can participate.

#### Target Audience

This guide will cover some important basics of options and is targeted towards those with no financial understanding of how option products work.

### Market Overview

Options trading is often dominated by large financial institutions and crypto firms in both traditional finance and cryptocurrency markets. Since 2020, options volume traded have skyrocketed 10x as we see more investors and traders move into this space for speculative or hedging purposes. The option markets with the highest liquidity are mainly BTC and ETH, however platforms are also actively developing new option markets for other altcoins.

A significant key difference between crypto option trading as compared to traditional finance option trading is the cost. Since crypto is one of the most (if not the most) volatile asset class on the market, this leads to crypto options priced significantly higher due to the high implied volatility factor.

Currently, key market makers in this space include: QCP Capital, Three Arrows Capital, LedgerPrime and many more.

As shown above, the volume of crypto options traded peaked in April 2021 just before the market crash we saw in mid-May when regulators in China started regulating the industry, restricting institutions from offering any crypto related services and closing down mining farms in the country.

BTC and ETH option interest have steadily bounced back from the crash we saw in May 2021. This phenomenon signals a strong demand for option products in the crypto market.

Currently, centralised platforms offering crypto options trading are dominated by a few firms, namely Deribit, OKEx, CME, LedgerX and bit.com with Deribit taking the lead with the largest share of the options market as shown above.

With the recent DeFi explosion. DeFi platforms have also started their own option trading offerings in the market. QCP Capital, for example, now trades more than US$1 billion in crypto options on DeFi platforms per month, and the firm also recently traded US$1 million in AAVE and Luna options on Ribbon Finance and ThetaNuts Finance, respectively.

From the Nansen Dashboard, we also observed that the quantity of transactions for Ribbon Finance and Stake Dao has fluctuated over time. The TVL on these two platforms, on the other hand, have been continuously increasing over time. While both platforms have been slowly introducing new option vaults that could attract new TVL, it could also imply that such option trading platforms are successful in attracting long term user usage.

### Understanding Option Basics

Option trading is generally considered to be more complex than spot trading due to the 3-dimensional nature of the product. - Factors include: time value of option, asset price direction, asset volatility, sensitivity to interest rates.

There are 2 styles of options available:

**American Options**: An option buyer can exercise the contract at**any time**before the expiration date.

**European Options**: An option buyer can only exercise the contract**at expiration**. Most crypto options (if not all), are European options.

There are 2 types of options available. You can both buy and sell options.

**Call Option**: If you buy a call option, it gives you the**right**to buy the underlying asset at a predetermined price. If you sell a call option, it gives you the**obligation**to sell the underlying asset if the option is exercised by the option buyer.

**Put Option**: If you buy a put option, it gives you the**right**to sell the underlying asset at a predetermined price. If you sell a put option, it gives you the**obligation**to buy the underlying asset if the option is exercised by the option buyer.

When you purchase an option, the price you pay to the seller of the option is known as “option premium”. Likewise, when you sell an option, you will earn the option premium from the buyer. The option premium is determined by several factors such as implied volatility. Most DeFi platforms that offer option trading such as Stake Dao offer automated sell-put strategies.

**Option strike price** is the price at which an underlying asset can be bought / sold.

- For example, if I buy a call option and the strike price and spot price is $100 and $120 respectively, then the option is considered to be “in the money” (ITM). However if the spot price is below the strike price, then the option is considered to be “out of the money” (OTM). If the strike price is equivalent to the spot price, then it is considered to be “at the money” (ATM).

#### Useful Option Profit Formulas

#### Option Payoff Diagram

Based on the option payoff diagram, we can understand the following points.

- When we long options, the max downside of our position is the option premium that we paid. This max downside is
*capped*.

- When we short options, the downside can be
*infinite*. For example when we short a BTC call option, and BTC spot price happens to skyrocket through the roof, this will expose us to unlimited risks.

**Buying**** Call Option Example**

You buy a BTC call option with a strike price of US$50,000 and to purchase this call option, you paid an option premium of US$500. A few days later, the spot price of BTC rose up to US$55,000.

Profit: $55,000 - $50,000 - $500 = $4,500

**Buying**** Put Option Example**

You buy a BTC put option with a strike price of US$50,000 and to purchase this put option, you paid an option premium of US$500. A few days later, the spot price of BTC dropped to US$45,000.

Profit: $50,000 - $45,000 - $500 = $4,500

**Selling**** Call Option Example**

You sold a BTC call option with a strike price of US$50,000 and when you sold the option you earned an option premium of US$500. A few days later, the spot price of BTC rose up to US$55,000.

Profit: $50,000 - $55,000 + $500 = - $4,500

**Selling**** Put Option Example**

You sold a BTC put option with a strike price of US$50,000 and when you sold the option you earned an option premium of US$500. A few days later, the spot price of BTC dropped up to US$45,000.

Profit: $45,000 - $50,000 + $500 = - $4,500

#### Black Scholes Model

The **Black Scholes Model** was developed in 1973 and is widely used today to price European style options.

If you are curious, this is what the Black Scholes Model formula looks like.

C0 = S0N(d1) - Xe-rTN(d2)

d1 = [ln(S0/X) + (r + σ2/2)T]/ σ √T

d2 = d1 - σ √T

Where C0 = option price

### Option Greeks

Option greek measures the sensitivities of option value based on a specific factor, holding the other factors constant. In total there are 5 option greeks, however *Rho* is not really used in crypto.

- Delta
- Gamma
- Vega
- Theta
- Rho

#### Delta

Delta shows how much the option will appreciate in value for each dollar increase in the price of the underlying asset.

- If delta = +0.1, then a 1 dollar increase in BTC should increase the option value by $0.1, assuming all other factors remain constant
- Based on the nature of both option types, call options have positive delta (0 to 1) while put options have negative delta (0 to -1)
- A positive delta means that you are long on the market and a negative delta means that you are short on the market
- Delta values are not static, they will change depending on “how in-the-money” or “how out-of-the-money” the option gets. They will also change based on how much time is left till option maturity
- Usually traders use delta as an indication on the probability of the option expiring ITM. E.g. ATM options have delta of around 0.5 (50-50 chance) whereas deep ITM and OTM options have deltas close to 1 and 0 respectively
- Traders can also use delta for hedging purposes. E.g. If a trader wants to hedge an existing call option with a delta of 0.5, he can hold another put option with a delta of -0.5 to hedge his position. The effective net delta is then 0. However, if you delta hedge, you will need to constantly readjust your hedge if not you risk over hedging your position

#### Gamma

Gamma is the ratio of the change of delta to the change in the underlying asset price. It answers the question of “how much does the delta change due to factors such as interest rate changes, volatility, etc).

Personally, I like to think of gamma this way:

When gamma is high, delta moves quickly like an ostrich on steroids, any slight movement in the price of the underlying asset will change delta significantly.

When gamma is low, delta moves like a tortoise who just had a few shots. You will need significant price changes to see any changes in delta.

- If you long a call or put, then gamma is positive and your gains will accelerate and losses decelerate
- If you short a call or put, then gamma is negative and your gains will decelerate and losses accelerate
- Gamma is highest when strike is close to spot price.
- Near option maturity, gamma is likely to be very high. Hence short term options are more risky than long term options
- Gamma hedging is also used to protect against both small and large price volatility, unlike delta hedging which only protects against relatively smaller fluctuations in prices. However for this guide, we will not be going into the specifics of these strategies.

#### Vega

Vega measures the sensitivity of the price of an option to changes in volatility. Options love volatility!

- Change in volatility affects both call and put options similarly
- If you long options, vega is positive, if you short options, vega is negative
- Based on the Black Scholes option pricing model, an increase in volatility will increase option prices, vice versa.
- Often, traders prefer option quotes in implied volatility rather than its dollar amount
- Vega is highest when spot price is near the strike price
- For example if an option value is $10, implied volatility is at 20 and the option has a vega of 0.15. Assuming that implied volatility rises from 20 to 22, that is a 2 volatility increase. Thus option price will increase by 2 x 0.15 = $0.3. The new option value is $10 + $0.3 = $10.3

#### Theta

Theta is the ratio of the change in option value to the decrease in the time-to-maturity. This is one of the most important concepts for a beginner to understand as it explains the effect of time on option premium.

- When we buy an option, we pay an option premium. And this premium will decay over time. The rate of this decay is known as Theta
- The longer the time to maturity of an option, the higher the option price - since it will have more time and probability of expiring ITM
- If you want to long options, it will be better to purchase options with a longer time to maturity. Likewise if you are planning to short options, you can also consider shorter term options that profit from the time decay, so that the option value decreases more quickly
- For example, if an option has a value of $10 and a theta of $0.5. After one day, the option value will decrease by its theta value of $0.5 and the new option value becomes $9.5

### Option Trading Strategies

In this section, we will talk about some common option strategies that are widely used by traders.

#### Simple strategies:

- Bullish on the underlying asset → You long a call option or short a put option.

As we mentioned earlier in this guide, should the asset spot price rise above the strike, longing a call allows you to capture the difference between the higher spot price and the lower strike price. Likewise shorting a put option allows you to earn the option premium which can be significant if volatility is high.

- Bearish on the underlying asset → You long a put option or short a call option.

Should the asset spot price go below the strike, longing a put allows you to capture the difference between the lower spot price and the higher strike price. Similarly, shorting a call option lets you earn the option premium.

#### Less simple strategies:

**1. Covered Call **

** When to use it**: Neutral to slightly bullish outlook

** Method**: Buy underlying asset + Sell a call option on the underlying

If you are OK with giving up some upside in return for option premiums then this strategy is useful for you.

If the underlying price rises significantly, your potential losses are capped as shown in the payoff diagram. The maximum profit potential is the sum of the call premium and the difference between the strike price and the underlying spot price.

Usually traders sell ATM or OTM options that have a higher chance of expiring worthless and you get to keep the option premium you received without further obligations. This strategy is most commonly done when volatility is high and expensive. Most DeFi platforms that offer option trading such as Ribbon Finance offer covered call strategies.

**2. Covered Put**

** When to use it**: Neutral to slightly bearish outlook

** Method**: Short underlying asset + Sell a put option on the underlying

Works essentially the same way as covered call, except that we are shorting the underlying asset and selling a put option. However if the underlying asset skyrockets, you will be exposed to unlimited risks. Also most commonly done when volatility is high and expensive.

**3. Bull Call Spread**

** When to use it**: Slightly bullish (Expects a moderate rise in asset price)

** Method**: Long call options at a specific strike while also simultaneously shorting call options at a higher strike. Both call options should have the same expiration date and underlying asset.

Bull spread has both a limited max gain and a limited max loss and is usually executed with call options but may also be done with put options. If you want to use put options, short put options with a higher strike and long another put with a lower strike.

For example if you want to speculate on BTC price increase with limited downside, then a bull call spread could be used.

**4. Bear Put Spread**

** When to use it**: Slightly bearish (Expects a moderate decline in asset price)

** Method**: Long put options at a specific strike while also simultaneously shorting put options at a lower strike. Both put options should have the same expiration date and underlying asset.

Very similar to the earlier bull call spread strategy. This also has limited upside and downside. Bear spreads are often done with put options but can also be done with call options nonetheless. If you want to use call options, simply short one call with a lower strike and long another call with a higher strike.

For example if you want to speculate on BTC price decrease with limited downside, then a bear put spread could be used.

#### More complex strategies:

**1. Long Straddle**

** When to use it**: Significant price movements but unsure of price direction

** Method**: Long a call and put option on the same underlying asset with the same strike and expiration date.

Technically this strategy allows traders to have unlimited upside and limited downside. Whereby the maximum loss is limited to the total cost of both option contracts combined. Traders like to use this strategy when they are unsure which direction the market will move but also want to bet on market volatility.

If you are a DeFi liquidity provider, you could technically use this strategy to hedge against impermanent losses as well, since price direction is not a key concern here.

For crypto markets, it's extremely risky to use a short straddle strategy due to the extreme volatility. Can you imagine if you short market volatility? The premiums might be juicy but if you are not an experienced options trader... don’t do it pal, its probably a suicide move.

**2. Long Strangle**

** When to use it**: Large price movements but unsure of price direction

** Method**: Long an OTM call and put option simultaneously on the same underlying asset and with the same expiration date.

This strategy is pretty similar to straddle, the difference lies in the different strike price of both options. Similarly, losses are limited to the total cost of both options.

Traders sometimes use strangles instead of straddles since they are almost always less expensive due to the OTM options.

### DeFi Option Platforms

**This list is not exhaustive. There are plenty of other option platforms out there.*

#### 1. Ribbon Finance

- Major platform for crypto structured products built on Ethereum
- Allows traders to use covered call and sell-put strategies
- Option strategies on Ribbon are automated. Users only need to deposit assets into the strategy vaults and the platform settles the rest
- Option Strategy TVL - US$196.8mm as of 8 Dec 2021
- Option underlying assets include $AAVE / $ETH / $USDC / $WBTC / $stETH / $yvUSDC
- Link

#### 2. Stake Dao

- Provides covered call and put selling strategies
- Option strategies are also automated, similar to Ribbon Finance
- Option Strategy TVL - US$39.6mm as of 8 Dec 2021
- Operates on BSC / Ethereum / Polygon / Avalanche chains
- I like the UI
- Link

#### 3. Hegic

- On-chain p2p options trading platform on Ethereum
- No KYC / registration needed
- Automatically exercises ITM options 30mins before expiration
- Hegic absorbs gas fees for trades with a min size of 10 $ETH or 1 $wBTC
- Link

#### 4. Opyn

- Capital efficient DeFi options trading protocol.
- Platform volume and liquidity is not the best.
- Automatically exercises ITM options before or at expiration.
- Link

#### 5. Dopex

- Option vaults only include $ETH, Dopex’s vanilla governance token $DPX and Dopex’s rebate token $rDPX.
- In-case of losses incurred by option pools, pool participants receive $rDPX tokens equivalent to 30% of all losses incurred by the pool.
- Is on Arbitrum as well.
- Link

#### 6. Theta Nuts Finance

- First cross chain structured products protocol on Ethereum and BSC.
- Offers Luna / Algo / TRX options unlike other platforms.
- Partners include Tron, Terra, QCP Capital, Fantom, Polygon and Defi Capital.
- Link