In an European option where the option holder cannot exercise their option prematurely before expiry, the option holder typically pays an option premium at t=0, and waits until maturity to determine if the option is in-the-money (ITM) or out-of-the-money (OTM).
In the event the option is ITM, the option holder exercises the option and profits an amount = the difference between spot price and strike price. In the event the option is OTM, the user gets nothing in return.
Because the option holder has to fork out the entire option premium at the start of the option lifecycle, capital is locked up and the holder has to manually unwind the position in the market. In the event that the market swings in a wildly unfavourable direction to the option holder’s view, the option holder will find that the value of unwinding the option would be close to 0, as the intrinsic value is 0 and time value is close to 0. In the illustration above, the option holder is stuck with a sunk cost of -10 which is the option premium.
In the PAYG model, the option holder is given a chance to hedge his risk of buying an option by paying for the option in instalments aka Buy Now, Pay Later (BNPL) options.
Compared to the traditional model of option sales, the option holder is able to observe the market, and in the event the option goes deeply OTM, the holder can choose to stop paying for the option if he holds the view that the market will continue to trend unfavourably until maturity. In the model below, the user achieves a lower loss up till t=7 compared to the traditional model.
Consistent yet sustainable returns: In this model, the upside for when the option is ITM is reduced, but the downside when the option is OTM is also reduced. Hence this results in a lower range of payouts for the holder and is more suited for extremely uncertain markets. In a highly uncertain market, there is value for option holders to strive for lower risk, lower return strategies to yield consistent yet sustainable returns.
Capital efficiency: Although buying options are inherently more capital efficient than outright longs and are sometimes viewed as leveraged with the credit risk being borne by the option buyer, the PAYG model further enhances an option's capital efficiency by allowing partial funding at the onset.
Transfer of credit risk: . Instead of forking out the full premium for options, buyers will be able to partially fund the option at the start of the tenor, with the remainder of the option risk being borne by the protocol. This results in a partial shift of credit risk from the buyer to the seller. In the traditional model, the option buyer takes on the credit of the option seller. If the option seller does not honour the option contract, the buyer may be left with little to no recourse in the absence of a clearing house. In the PAYG model, because the option seller relies on the option buyer to fulfil an obligation to continue paying the price of the option, some of the credit risk is now offset from the buyer to the protocol.
Real-time market feedback: The option buyer is able to continually monitor the market outlook and decide the default on the option purchase. If the market swings in a wildly unfavourable direction to the option buyer's initial view, the option buyer may re-assess the position and choose to cut loss by wilfully defaulting on the option premium. Option default risks are appropriately priced in via structuring models in collaboration with market makers.
Options are not widely understood, and even those with the theoretical knowledge of option pricing may find trading in the options markets daunting, because in essence, option trading requires not only a correct view on the direction of the market, but equally important is the correct velocity at which market prices will move.
This is why we have created the PokPok protocol, which aims to make options investments palatable and easily understood by all. In addition to pioneering the BNPL model for options, education via gamification and entertainment via fun games is something we seek to achieve.
A simpler way to break down the economic theory behind BNPL options is to think about the insurance markets. The economic principle behind BNPL options is essentially allowing users to buy market-priced insurance on their options should there be a need to cut losses and default.
L = number of losing positions
F = % of defaulted losing positions
Z = total number of options purchased in protocol
P = normal price premium of an uninsured option
p = additional premium for BNPL options
d = % downpayment on BNPL option premium
s = remainder of servicing fee for BNPL options
W = number of winning positions
A = % of winning positions
The theoretical pricing formula for BNPL options is given by the following formulae:
Premium charged for BNPL option = P(1+p)
Pricing additional premium: pZ = (1+p)(P)(AW) + (1+p)(P)(d) - (FL)(s)
p = [(1+p)(P)(AW) + (1+p)(P)(d) - (FL)(s)]/Z
The value of p will have to be constantly rebalanced and subject to regression testing to determine the fair market price.
The above pricing model achieves two very important economic aims in the value proposition of this model, which is to increase capital efficiency and redistribute returns such that, given that no single investor can always make the right directional call on markets, buffer downside risk by capping upside returns. This narrows the standard deviation and allows a more consistent level of returns over time.
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