Introduction to Crypto Options (part 1)

A succinct overview (part 1)

Martijn Dingeman Ardon
Feb 28, 2023

Researching new verticals in crypto is pivotal to Fourstacks Ophir Strategy. One of these newer on-chain verticals we expect to take off is on-chain options.  Exchanging digital assets and trading on margin or leverage is happening increasingly on-chain. We expect a similar trend to materialize for other crypto products such as options. 

Options are financial instruments that provide traders with the right, but not the obligation, to buy or sell an underlying asset at a specific price, known as the strike price, before a certain expiration date.  In crypto, options are a popular tool to hedge risk and speculate on price movements. While the centralized finance space has seen an increase in options volume in recent years, the DeFi options market has struggled to gain traction. So far, Deribit has absolute supremacy with a full stranglehold over the crypto option space. 

Options are useful because they provide traders with flexibility in their trading strategies. For example, traders can use options to protect against market volatility or to profit from price movements. Options also provide a level of risk management by limiting potential losses. Additionally, options can be a way for traders to gain exposure to an underlying asset without the need to purchase it outright.

There are several notable DeFi options protocols that have been developed, such as Ribbon, Lyra, Opyn, Hegic, Dopex, Premia and Buffer. Despite progress and product market fit in other DeFi subsectors, the growth of these protocols has been underwhelming. However, recent advancements in DeFi options design have shown promise. Let us introduce a few of them in this article.

Lyra Finance 
Lyra is a DeFi options protocol on Optimism and is a cornerstone of the maturing Synthetix ecosystem. Lyra allows users to trade cash-settled European options fully on-chain via its AMM. However, like other options protocols, Lyra has struggled in its battle with centralized options exchanges. With the recent launch of its Avalon update, Lyra is poised to battle CeFi giants for market share as it asserts itself as a worthy contender.

Lyra is a DeFi options protocol that has shown promise in its ability to offer a near-complete options trading experience without the off-chain concessions of its peers. Lyra's novel delta and vega hedging features protect liquidity providers, and its dynamic fees can sometimes heavily penalize users selling options back to the AMM, boosting the value proposition of Premia's American options and sell-back feature. Currently, Lyra only offers cash-settled European options, which may not be suitable for traders who prefer American-style options or options with longer expiration dates.

Hegic is a decentralized options protocol that was one of the first DeFi options platforms to launch. It allows traders to select any strike price and provides liquidity for options trading. The protocol is designed to enable fully on-chain, peer-to-pool trading of non-custodial options for ETH and WBTC.

However, the protocol had many problems in its initial launches, such as the manually updated implied volatility oracle, high prices, and liquidity providers (LPs) experiencing significant losses. To address these issues, Hegic released a new version of its protocol called "Hegic Hardcore". Hegic Hardcore has pivoted to offering split liquidity pools for calls and puts, as well as providing easy access to one-click options strategies. This version of the protocol also uses an improved implied volatility oracle and offers better pricing for options trading.

Premia is a decentralized options protocol that offers American-style options with relatively competitive prices. It uses an automated market maker (AMM) to price options and offers non-custodial trading for both call and put options. Premia's options contracts are settled in USDC, and it offers options trading for several underlying assets, including ETH, BTC, and stablecoins like USDC and DAI.

One of the key features of Premia is its off-chain implied volatility (IV) calculation, which is based on real-time market data obtained via Chainlink oracles. This allows the protocol to offer competitive pricing for options contracts.

However, one of the main drawbacks of Premia is its capital inefficiency. The protocol uses single-sided vaults for each asset, which means that it can suffer from fragmentation of liquidity. Traders can only buy, not sell, options on Premia, which can limit the utility of the platform.

Opyn is another decentralized options protocol that allows users to create, trade, and settle options contracts. The protocol aims to bring options trading to a wider audience by offering a simple, user-friendly interface and a range of different option types. It tries to do this by using a unique smart contract design that allows for capital-efficient options trading. This means that users can create options contracts with lower collateral requirements compared to traditional options trading, which can result in higher leverage and potentially higher returns.

Opyn offers a range of different option types, including European and American options, as well as options with different strike prices and expiration dates. This variety of options allows traders to tailor their trades to their specific needs and to take advantage of different market conditions.

While promising there are several drawbacks beginning with the fact that Opyn relies on a centralized oracle for price feeds. This is potentially vulnerable to attacks or manipulation. While the Opyn team has implemented measures to prevent these types of attacks, there is always a risk that the oracle could be compromised, which could result in incorrect pricing information and financial losses for users.

Also, as with many Ethereum-based protocols, using Opyn can be expensive due to high gas fees during periods of high network congestion. This can make it more difficult and expensive for users to engage with the platform during peak trading periods. Their presence on other Layer-1s or Layer-2s is very limited as of right now.

Final Thoughts
Fourstack's opinion is that option protocols need to be built on a solid foundation, with a multi-chain focus and decentralized pricing data. In this regard, both Opyn and Hegic fail. Without a multi-chain focus will continue to bleed against their counterparts that do aggressively go multi-chain. A higher addressable market of both investors and users is important and will get the desired network effects in regard to liquidity to compete with Deribit. However, currently, not one protocol is getting even close.