Since the overall market sentiment is ultra-bearish and investors are gradually rotating back in stables or blue-chips, I thought it would be timely to introduce one of my favourite methods for generating sustainable yield on your current crypto-holdings. If prices aren’t appreciating like they were in a bull market, we might as well think of low risk ways to accumulate our favorite tokens in preparation for the next bull run. DeFi Options Vaults allow you to do just that in a sustainable and relatively low risk manner.

What are DeFi Options Vaults (DOVs)?

Put very simply, they are DeFi protocols that allow users to deposit their cryptocurrency assets and earn yield. If you have heard of robo-advisors before, you can imagine DOVs are very similar in concept — set it and forget it. You may ask, where does this yield come from?

Current iterations of DOVs typically generate yields for users from three main sources. Firstly, deposited assets are deployed into various options strategies (with the deposited asset as the underlying) to generate yields from premium gains, hence the name DeFi Options Vaults.

Next, some protocols reward active users with their own native governance tokens for added yield. For example, Dopex incentivizes users with its $DPX token.

Last but not least, the assets staked in the vaults can also earn staking and governance yield for the user.

What type of Options Strategies are used?

The lion’s share of a vault’s yield comes from the option strategy in which the staked asset is deployed into, so it makes sense to understand a bit more about such strategies.

Most of the current offerings utilize two main options strategies: vanilla covered calls and cash-covered puts.

Strategy 1: Covered calls

In this strategy, passive yield is generated from selling (otherwise known as writing) a call option on an owned asset. The option seller i.e. the depositor, earns a premium from selling the option to the option buyer, but gives up the right to purchase the asset at the option’s strike price if it expires in-the-money (ITM).

Strategy 2: Cash-covered puts

Similarly to the first strategy, the cash-covered put strategy involves selling a put option on the owned asset to earn yield via the option premium.

I won’t go deep into the details of each strategy, but if you are interested to learn more, I found the 2 videos here helpful in their explanations:

Genesis Volatility’s “Selling Covered Calls — The Original Yield Farming”

InTheMoney’s “How to Trade Cash-Secured Puts”

Whats the big deal with DOVs anyway?

Great question. You might look at the juicy APYs paid out by the latest DeFi protocols and scoff at the comparatively lower yields generated by the common options vaults available. What differentiates DOVs from the rest of DeFi and why should you be paying attention?

1. High Organic Yield

The aforementioned DeFi protocols are usually able to provide such high reward percentages because of token emissions. The large bulk of a DeFi protocol’s APY is usually provided by the protocol’s native governance token, instead of in the deposited asset or stablecoins.

This begs the question, are such yields sustainable in the long run? While the degen in me would like to think so, the reality is that there’s no free lunch in this world and these otherworldly yields are simply not sustainable, or at least not without any tradeoffs.

DOVs on the underhand, derive their yield from selling options to earn premiums, which is a strategy that works especially well in crypto where the implied volatility of crypto-assets are generally extremely elevated when compared to traditional assets like equities, commodities and foreign exchange. This means that option sellers are able to earn a much higher premium selling an option on Bitcoin instead of an option on Tesla for example.

Not only are these yields attractive currently, these yields do not rely on token rewards and are therefore more sustainable. As long as there remain option buyers available to purchase the written options, premiums can still be earned from such strategies. While the implied volatility of crypto will likely taper off as the years pass, the market for crypto derivatives is very likely to remain. For reference, just take a look at similar volatility harvesting/selling strategies employed in the TradFi space.

One the largest consumers of such strategies are your private banks, who offer these vol-selling structured products to their clients as an attractive yield generation investment. Despite the comparatively lower implied vols, the yield generated is still sufficient for these end clients, which shows that there will always be demand for yield generating strategies even as these yields diminish over time. Coming from a TradFi background myself, I can see that the opportunity for structured products can be massive as these instruments have traditionally only been made available to High Net Worth Individuals or priority banking clients. The permissionless nature of DOVs democratizes the playing field by granting access to anyone with funds and a wallet.

2. Access to non-linear products

While exchanges like Deribit have allowed both retail and institutional players to access both crypto options and futures, native DeFi market access remains largely poor. Unlike linear instruments like spot crypto or crypto futures, both expiring and perpetual, decentralized exchanges are unable to price and manage non-linear products like options well.

This is where DOVs comes in and melds the best of centralized and decentralized options management. The difficult parts of managing options on-chain, like risk management and liquidations, are now executed off-chain in the same vein as Deribit. This leaves collateral management, price discovery and settlement to be executed on-chain. In this hybrid model, only the parts that require decentralization and permissionlessness are executed via smart contracts while the rest can be outsourced.

Furthermore, like I mentioned, crypto options are an excellent source of yield within DeFi that all retail investors should be able to access. However, it can be daunting for an investing beginner to dive into the options space when even the spot environment is challenging enough. DOVs present an elegant solution to this problem with their “set it and forget it” concept, which is easy for beginners to understand and access.

We need only look at traditional equity markets to see a similar comparison. Choosing which stocks or ETFs to invest in can be an intimidating process, but robo-advisors like Endowus simplify this process by handling the decision-making process for you — all you have to do is fill out a questionnaire on your risk profile and deposit your funds with them and you are good to go.

While DOVs have not been to achieve this level of ease of use and widespread use, they utilize a similar concept, providing investors with just enough information but not overloading them with technicalities. Users only need to know a few key things, what yield they can expect to earn from their investment, what collateral/token they require to participate in a particular vault, and of course some simple explanation of the underlying option strategy.

A look at some notable DOV protocols

Enough talking about why we should be paying attention to DOVs and lets start looking at some options already available to the masses. For this section, I will be looking at 3 main protocols that I have been using personally, Dopex, Friktion and Ribbon Finance.

Dopex

Dopex, or Decentralized Options Exchange, offers 2 main products: options pools and Single Staking Option Vaults (SSOVs). For the sake of this analysis, we will only be looking at Dopex’s SSOVs. These SSOVs are available on 3 chains at the moment, Arbitrum, Binance Smart Chain and Avalanche.

How do these SSOVs work? Well, there are variety of vault options that allow users to deposit their crypto-assets as collateral. These vaults operate on an epoch basis, which is quite common within the DOV space, whereby deposits and withdrawals are only allowed between epochs which are typically at the end of each month. This is because the options written by these vaults are all month-end expiry options, therefore it just makes sense to let users deposit their collateral at the start of the month and to claim their collateral and premiums at the end of the month.

Dopex Discord announcement on upcoming epoch

Once the 72 hour deposit window opens up, DeFi degens like you and I can then select which option strike prices they wish to provide collateral to. As you can see in the screenshot from Dopex’s discord server, each vault typically allows you to select one of 4 OTM (out-of-the-money) strikes.

At the end of the deposit window, options buyers are then able to purchase the calls/puts written in these vaults, and premiums are allocated to depositors based on their share of the total collateral for the particular strike.

Basic deposit information

The interface is easy to understand and gives you all the information you need, such as how much of the particular crypto-asset has been deposited into each strike, which tells you what percentage share of the premiums you can expect to receive. In my case, I had some spare AVAX lying around so I decided to deposit 5 AVAX into the $115 strike and 15 AVAX into the $130 strike (yes this was done a few months back when market was still pumping). As you can see from the screenshots below, the premiums earned from selling the $115 strike is logically much higher than selling the $130 strike, albeit of course at a higher risk of losing your collateral when the option is exercised. In my example, I was making similar premiums.

Granular deposit information per strike

Granular vault information per strike

Dopex is definitely one of the strongest offerings within the DOV space, with a wide selection of vaults to choose from and a killer community to boot. Being able to select the strikes you deposit into is nice, as it caters to a variety of risk appetites and market conditions. Market trading sideways? Sell some close strikes to earn juicier premiums. Market pumping but still want to earn some yield on your cryptos? Sell some far strikes. The UI is also very clean and concise as well, giving you just enough details without inundating you with information. Overall, the user experience is quite easy to use in my opinion.

A potential shortcoming of Dopex is actually related to one of its strengths. While being able to select your strikes is a boon to DeFi enthusiasts, more casual crypto-curious users might prefer a simpler, more automated approach which reduces the burden of decision-making on the user. I think that as the space matures and more people start realizing the potential of these vaults, applications will need to simplify the investment process for users, similar to robo-advisors in the TradFi asset space.

Friktion

Friktion is currently Solana’s largest options and structured products protocol with about $129m TVL, deposited across 15 different crypto-assets in addition to stablecoins like UST and USDC. Friktion uses the same underlying concept as Dopex and other DOVs, generating income for depositors by either selling covered calls or cash-covered puts. Its vaults are split into Volt #01 and Volt #02. Volt #01 focuses on covered call selling while Volt #02 focuses on generating yield on stablecoin deposits via cash-covered puts selling.

I had some residual SOL unused in my Phantom wallet when I discovered Friktion, so I decided to deposit this into their SOL vault to learn more about the interface. They key difference from Dopex here is that Friktion depositors do not have to worry about selecting strikes on their sold calls (recall I had spread my AVAX between $115 and $130 calls). According to Friktion, strikes and expiries are algorithmically determined to maximise your returns and minimise the chance of being exercised or having the underlying asset assigned.

This is immediately a huge differentiating factor for me as a lazy investor. Set it and forget it is the name of the game here, letting the protocol decide what strikes are most optimal takes a huge amount of decision-making out of the process, reducing the friction (get it?) for the less degen members of the crypto community. Being able to treat the protocol like a savings account that generates yield for you simplifies things greatly and I believe is key to driving mass adoption. We need only look at Anchor Protocol on the Terra blockchain for a shining example of simplicity driving adoption — $15bn TVL, 54% of total Terra TVL, need I say more?

BUT, for the degens among us, Friktion did introduce some form of increased risk-taking recently. In exchange for a higher chance of your option being exercised i.e. less OTM strike, you are able to earn a higher APY on your deposits, simple as that.

Friktion’s Solana Volt at a glance

Ribbon Finance

Another heavyweight OG in the ETH DOV space, Ribbon Finance focuses on a similar target audience to Friktion — the more risk averse crowd looking to earn yield on their assets. Unlike Dopex that allows degens like me to select closer strikes to earn higher premiums, Theta runs a fully automated vault strategy. Theta Vaults, as they are called, works in the same “set-and-forget” manner as Friktion. The protocol has since expanded to both Avalance and Solana as well, attracting $304m in TVL.

Ribbon’s Theta Vaults utilise Opyn’s oTokens at their core to represent options contracts, with each token having a strike price and expiry. Therefore, owning an oToken is functionally equivalent to owning an option contract, giving the holder the right but not the obligation (brings me back to Derivatives 101 in uni) to redeem some amount of the underlying asset if the contract expires in-the-money.

I won’t go into deep detail in this piece about how Opyn’s oTokens integrate with Ribbon’s Theta Vaults, but if you are interested you can read more here: https://medium.com/opyn/understanding-perpetual-vaults-in-defi-structured-products-with-underlying-options-strategies-27610254475e

Ribbon Finance Slide Widget

The thing I like about Ribbon is how it explains the concept of DOVs to new users. Within each vault, depositors can click through a simple slide widget that explains in simple terms how the protocol takes the deposits and mints options to generate yield. It also explains the financial outcome of the 2 possible scenarios — ITM and OTM expiry. This definitely makes it more friendly to those less familiar with options and options selling strategies, which I am a big fan of.

Concluding thoughts

Anchor protocol has demonstrated how a simple savings account like protocol can attract billions in TVL and fuel interest in the broader Terra blockchain ecosystem. Applying this similar concept to the rest of blockchain, I am a firm believer that DOVs will form the foundations for future capital inflows into crypto, providing attractive but sustainable yields to the crypto-curious masses.

However, I can’t stress enough the importance of building a great user interface and experience in attracting and retaining new users. While degens like you and I are used to shitty interfaces (cough Metamask cough), the non-crypto enthusiast is used to sleek and shiny apps outside of crypto. Therefore, such protocols aimed at attracting funds from such users will need to invest more in streamlining the user experience, from onboarding to depositing to withdrawal.

Given crypto’s questionable rep in the broader community, extra attention needs to be given to explaining how these DOVs work as well. Ribbon Finance and Friktion are great examples of this, Ribbon with its easy to understand interface and Friktion with its educational content.