Understanding Options
Basic regular options concepts are key to better understand DeFi Options
Lately in the Defi community, we have been talking a lot about options and how they can be used or done in the Ethereum and DeFi space. It is a super exciting and fast-paced environment that is constantly finding new solutions for finance products that have been around for quite some time.
Clearly DeFi options are different than traditional ones for a few reasons. However, it is good to understand the basics of options as they are used in traditional finance.
In this post, I expect to go through the regular functioning of options as an investment product in traditional finance. In a follow-up post, I will review DeFi options and share some of the main differences between regular and DeFi options.
If you are also interested in derivatives, options and DeFi, join our Discord channel!
What are options?
Options are a well-known kind of derivative in traditional finance, and they represent a commitment (of the seller) and an opportunity (for the buyer) to either buy or sell the underlying asset upon expiration, depending on the contract they hold. The contract is issued by the seller and, unlike futures, it represents a right, but not an obligation, of the buyer to exercise the contract terms if s/he wants to.
The concept of a contract that allows the buyer to hold a right that is not an obligation is the most basic and inherent feature of every options contract. Besides that, there are different types of options, types of exercising rules, and types of settlement that can be tweaked to get your best option.
Options types and flavors
There are two types of options: calls and puts.
A call option allow the holder to buy the underlying asset, at the strike price.
A put option allow the holder to sell the underlying asset, at the strike price.
Another important characteristic of options regards the rules to exercise the contract. Options can be either American or European options. An American option is a “continuous time instrument” because it allows the buyer to exercise it at any moment until expiry. A European option is a “point in time instrument,” since it allows the buyer to exercise only when the expiration is reached.
An option can be exercised in two ways: cash or physical settlement. Cash settlement assumes that only the difference between the counterparts should be offset, which also means that the margin required for the contract to be valid could be smaller. On the other hand, physical settlement assumes that all the collateral or margin held in custody will be exercised.
How options work?
To start interacting with options, one should first choose between the following basic characteristics of an option contract:
- Type of right: put (right to sell) or call (right to buy)
- Type of exercising: American or European
- Type of settlement: cash or physical
Once that is decided, one should pay attention to the following details:
- Underlying asset
- Strike price
- Strike asset
- Expiration date
- Premium
The underlying asset is the object asset — the asset people want to have the right to either buy or sell in the future.
The strike price is like the trigger price. It is the price that informs both counterparts that the agreement can be exercised.
The strike asset is the asset that will be delivered in return to the underlying asset upon expiry.
The expiration date informs how long this contract is valid.
The premium is the current market price of an option contract. It is the income or reward that the option seller gains in order to write and sell the contract. And thus, the price that the option buyer pays to the seller, so that it can hold the contract until expiry. The premium is paid upfront.
Pricing
There are several models for pricing options in traditional finance, and the most widely known is Black-Scholes. Black-Scholes is a mathematical model for pricing an option contract, and this model assumes, among other things, that the asset’s volatility remains constant over the option’s life (which is not applicable — especially in crypto). The formula is applicable only to European options (and to American calls on non-dividend paying assets).
The mathematical notation of it is:
Other models are also commonly used, such as the binomial model and trinomial model.
But another deal breaker here is that most models use the risk-free interest rate (usually US treasuries rates) to estimate the premium. It is hard to do it in the crypto environment, though.
Evaluating an option
After an option is issued and sold, the holder of the option will analyze certain market conditions in order to make a decision whether to exercise it or not.
We say that an option is in-the-money, if the event of exercising it will incur in a positive payout for the option holder in both cases, puts and calls. For instance, being in-the-money for a put option means that the spot price (current market price for the underlying asset) is below the strike price. Meaning, if the option holder (user that bought a put option in the past — holding the right to sell the underlying asset at strike price upon expiry) exercises, s/he will sell the underlying asset for a price (strike price) that is currently higher than the spot price. In the case of a call option, being in-the-money means that the spot price is higher than strike price.
On the other hand, we say that an option is out-of-the-money when the opposite occurs. In other words, it is when it makes no sense for the option holder to exercise the option.
So, keep in mind that to calculate the value of an option, one should always compare the spot price and the strike price of the underlying asset, depending on the option type.
That's it!
Now you have an understanding of the basic concepts about options. 📑
Share your questions and ideas at our Discord channel, and let’s build DeFi Options together. 🙏🏻
About Pods
Pods is a decentralized non-custodial options protocol. Users can create options and trade them through an Options AMM on the Ethereum Blockchain. Pods is the easiest way to hedge crypto in DeFi.
We invite you to take the first step in your new mission: start testing the app on app.pods.finance
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