2021 has been an excellent year for crypto trading. The pie has been increasing so fast that all types of exchanges — centralized and decentralized, spot and derivatives, have seen an enormous increase in volumes. The year also witnessed a rise in options usage in the crypto space, both off- and on-chain, with on-chain options finding a product-market fit mainly in short volatility yield farming strategies introduced to the market by Ribbon.
This article aims to give an introduction to options and volatility trading, an overview of the market structure in both traditional finance and DeFi, and different designs of options exchanges, including power perpetuals (aka Squeeth), which is the new derivative that shares many features of options.
The crypto industry has historically been very innovative regarding new financial instruments. Due to the market structure and new technology stack, TradFi copy-pasted solutions often gain only limited traction, while the real breakthrough happens when a new crypto-native design is being invented.
In 2016 Bitmex introduced perpetual swaps that became the biggest market in crypto, well ahead of traditional futures in terms of volumes. Up until then, perpetual futures were a theoretical concept. Then, Bancor and Uniswap have pioneered automated market makers (AMM) as an alternative to a central limit order book (CLOB) decentralized exchanges, which led to a boom in on-chain spot trading. With the emergence of Layer-2 solutions, decentralized perpetual swaps exchanges started gaining momentum. dYdX utilizes CLOB structure, while Perpetual Protocol is built with a virtual AMM.
The options market is dominated by Deribit, which has witnessed a massive increase in trading volume over the last two years. Daily average volume increased by 474% this year, from $176m in 2020 to $1.08b in 2021 across BTC and ETH markets.
On-chain options volume increased even more substantially, though not because people started trading options directly. Instead, the growth is fueled by DeFi compatibility, more precisely Ribbon Finance's option selling strategies launched earlier this year. While it's true that on-chain options found their product-market fit, they are currently limited with two short volatility strategies, namely covered call and short put.
Option pricing theory is a complicated topic that is out of the scope of this article. Therefore, I only stress things that, in my opinion, are relevant for on-chain options & Squeeth.
There are four ways to trade options — long call/put and short call/put. Long gives you a right but not obligation to exercise an option, while short (or writing) an option provides an obligation to execute the contract.
Buying options is an attractive strategy as it provides a nonlinear payoff. To go long call, one pays a premium — the price the writer gets to take the other, unfavorable from risk-rewards perspective, side of the deal. Thus, the long call strategy has an unlimited upside for a fixed upfront cost. It's similar for long put, except that the payoff is limited with the underlying reaching zero. We need to look at the delta to understand options nonlinearity (convexity, or gamma).
Delta is the first derivative of the option price with respect to the price of the underlying. It shows how much the option's price will change with one dollar change in the underlying. For instance, let's say ether is at $4,000, the at-the-money call has a delta of 0.5 and costs $400. As ether goes to $4,002, the price of our call will increase by ~$1 to ~$401. Since the right to buy the underlying can't be worth more than the underlying itself, delta is bound between zero and one. For a call, delta will be approaching one as the price of the underlying moves deeper in-the-money and zero as it moves further out-of-the-money.
The picture below shows that delta is only a linear approximation of a curved function representing the option value.
Gamma is the second derivative of the option value with respect to the underlying — it measures the rate of change in the option's delta. Gamma is the convexity of options. Being long gamma means that as the position moves further in one's favor, the more money one makes on each additional dollar of a price increase in the underlying. And the further the position moves against, the less one loses with each extra dollar of price decline in the underlying. Gamma is not constant and reminds a bell curve with its peak at a strike price, as shown in the graph below.
Out-of-the-money options are the best way to take advantage of gamma.
Gamma is the best friend for naked options buyers, but of course, it doesn't come for free. Theta, or a time decay of the option, is always the opposite sign of the gamma, and their magnitudes are directly proportional. Intuitively, the closer out-of-the-money option is to the expiry date, the less value it has as the chance for expiry in-the-money decreases. So, there is a tradeoff between the time to maturity and convexity.
Both retail and professional asset managers tend to trade options to the long side. Proprietary trading firms specializing in market making provide liquidity by taking the opposite side of these trades. This doesn't mean that they necessarily have an opposing view on the market; instead, they hedge the directional component of the option out with dynamic hedging. What they trade is volatility. Option sellers always buy the underlying as the price goes up and sell as the price goes down, while options trade it the other way around. Hence, going long put or call means being long vol, going short put or call means being short vol.
For instance, ether is at $4,000, and volatility trader just sold 10 at-the-money ether call contracts with 0.5 delta. To net out the directional component, a trader would buy 5 ether. Say, the next moment ether drops to $3,000 — then a trader, to stay sufficiently hedged, will have to sell a portion of the ether they just bought at a 25% loss. Likewise, if the ether price goes up to $5,000, a trader will have to buy more ether at a 25% higher price to maintain neutrality.
Volatility trading is a huge business, especially as options get more momentum. However, it has historically been a niche for professionals due to its complexity as it requires significant investments in infrastructure and human resources.
CBOE Volatility Index (VIX), the most successful CBOE product, derives the volatility traders expect on S&P 500 index for the following 30 days from SPX close-to-expiry options. VIX itself is not tradable by nature as the index is mean-reverting. However, the VIX ecosystem has grown enormously since the index was invented, with ETFs, ETPs, futures, and options structured around it to offer the general public a way to trade volatility.
Now, knowing the basics of options and vol trading, let's see how the landscape looks like in crypto.
When it comes to centralized exchanges, Deribit dominates the market. It has become the most liquid option exchange as it could attract both market makers and retail traders. The market structure on Deribit is the same as on traditional markets (described above).
For decentralized options, there are three main challenges the platforms face, not considering high transaction costs expressed in gas fees:
Liquidity
The flexibility of choosing expiration/strikes
Capital efficiency
Let's examine three main options DEXes and the tradeoffs they take to solve these issues.
Opyn utilizes a classic TradFi option chain design, which makes it similar to Deribit. This approach provides maximum flexibility as option sellers have no constraints on expiry dates, strikes, or option prices. It's also easily scalable — if there is a buyer and seller on contracts worth $100m, the Opyn infrastructure can easily settle the trade.
On the other hand, this option chain design leads to liquidity fragmentation. Instead of concentrating all the liquidity in one single instrument, it spreads between different strikes and expiry dates. As a result, market makers don't want to commit substantial capital to spread over multiple option series, and traders are disincentivized from trading due to a lack of liquidity. Moreover, capital inefficiency (high minimum collateral ratio) worsens the matter further.
Hegic has adopted a crypto-native way to source liquidity for options that they call peer-to-pool. As the name suggests, option buyers don't trade against a particular party but rather against liquidity providers, who collect premiums and take losses. This design solves the liquidity fragmentation problem, accumulating all the liquidity for one instrument in a single pool.
The cost of liquidity concentration is limited flexibility for both buyers and sellers. Liquidity providers (option writers) have to lock their funds for 30 or 60 days and take the opposite side of those buying options. Although there are separate pools for put and call writers in the last version of the protocol, blindly writing naked options is a hazardous strategy over time, especially in such a volatile market. Total value locked in Hegic's liquidity pools has decreased by 80% to ~$16m over 2021, likely due to risks and poor performance of these pools. Hegic offers auto-hedged pools that yield 3%–4% APY, though the hedging is not transparent as done off-chain.
For buyers, there is a particular set of constraints as well. First, there is no strike selection — Hegic allows to trade only at-the-money options. Hence you can't take full advantage of gamma (remember, gamma peaks at-the-money). Also, the time to maturity is limited to 30 days as of now.
The implied volatility (IV) used to price the options is imported from Deribit and decreased by a fraction to make options a little cheaper.
Lyra is an automated market maker for options. The concept is very similar to AMMs such as Uniswap, but instead of determining the market price of a particular asset, it determines the market implied volatility for a specific option. Hence, each option buyer for a specific option will push implied volatility higher, and each seller will push it lower. As it's probably unrealistic to have a perfectly hedged pool based on demand and supply, Lyra uses two additional mechanisms to protect liquidity providers: delta hedge and vega hedge.
Lyra's liquidity pools are divided into two parts: collateral pool and delta pool. Delta pool is designed exclusively to hedge out a directional exposure to the underlying. Thus, if the pool's delta is net positive, meaning there are more option sellers than buyers, the delta pool will short the underlying on a spot exchange and vice versa.
Vega risk is maintained by a variable fee built in the options price depending on the pool's vega exposure. For example, say the protocol has a sizeable negative vega exposure, meaning people tend to buy options (long vol) rather than sell (short vol). In this scenario, the protocol will add a higher variable component to a price for an option it sells than for an option it buys to compensate liquidity providers for taking on additional risk.
Lyra is a significant step towards an efficient options AMM as it enables a functioning market for both buyers and sellers while protecting the liquidity providers. Yet, it still has some limitations due to its design. For instance, maturities are limited to 7, 14, 21, and 28 days, which is the round length for which liquidity providers lock their money. In addition, strike prices are restricted to ~25% around the current market price.
The last existing protocol I will mention is Ribbon. Unlike all previous projects, it's not an options exchange — it runs automated option-selling strategies that generate yield. These strategies open short volatility strategies to a larger audience, not necessarily familiar with options. Ribbon has different vaults such as USDC put-selling strategies and ETH covered call strategies. By selling far out-of-the-money options on a weekly basis, Ribbon was one of the first to provide sustainable yield farming. Of course, option selling strategies imply risks, however in almost 9 months since inception, the strategies have been profitable.
Ribbon uses Opyn v2 to write options as Opyn is the only protocol that allows a significant amount of flexibility in terms of maturity and strikes and is easily scalable. Ribbon's most significant challenge to overcome was finding a counterparty that would buy large chunks of options — now Ribbon sells close to $200m weekly. Market makers, such as QCP, jumped on this job — as described at the beginning of the article, they hedge out the directional component to purely trade vol.
Ribbon and its option short vol strategies have become the product-market fit for on-chain options. Since the launch of Ribbon vaults in early April 2021, it accounted for >95% of Opyn's volumes. TVL of both projects skyrocketed to over $200m.
Power perpetuals are a new financial instrument whose payoff follows the underlying to some power. For example, power perps can replicate a payoff of ETH², ETH³, etc. You can read more about power perpetuals in the original paper.
There are interesting implications to some powers: ETH^0 is a stablecoin, ETH^1 is a perpetual swap, ETH^(1/2) has the same payoff as Uniswap v2 ETH/USDC pool, also available for short. One can already see multiple use cases for different power perpetuals, but the most interesting, in my opinion, is ETH^2, which is also called Squeeth (squared ether).
As ether goes up by 1.5x, Squeeth goes up by 2.25x, as ether goes up by 2x, Squeeth goes up by 4x, and so forth.
While it shares many features of options, Squeeth is a brand new exotic instrument that is being developed by the Opyn team. It has a very crypto-native design, taking advantage of numerous past innovations that proved successful in crypto.
Like perpetual swaps, it has funding that links the price to an index. Funding is paid continuously and equals to mark-index, where "mark" is the market price of Squeeth and "index" is ETH². Theoretically, longs always pay shorts for taking the unfavorable side of the deal of short convexity.
To mint Squeeth, one will have to lock ETH as collateral and maintain the position above a certain collateral ratio, similarly to borrowing USDC against ETH on Compound.
The Squeeth's trading venue is Uniswap. To short Squeeth, one needs to mint it and sell it to ETH/SQTH pool. Short sellers can be liquidated if the collateral ratio goes below a certain threshold. To long Squeeth, one needs to buy it on Uniswap. There is no liquidation risk for those who long Squeeth; the funding fee is paid in-kind.
Squeeth is the first power perpetual to launch in the coming months.
Squeeth is a representation of an option chain in a single instrument. That solves the liquidity segmentation problem and significantly lowers transaction costs. To understand the tradeoff between liquidity and flexibility, let's examine Squeeth's greeks. The payoff function is x².
Delta is the first derivative of the price and equals 2x. However, delta is only a linear approximation of a curved function. Hence Squeeth behaves as 2x leveraged ether only on a limited portion of the curve.
Gamma is the first derivative of the delta. In this case, it's constant and equals 2. Gamma is the convexity of options, and Squeeth behaves as an always at-the-money call.
Theta is time decay. In the case of Squeeth, theta is the funding fee, paid continuously.
Vega is a sensitivity of an option to changes in implied volatility. For Squeeth, vega will be positive — as implied volatility increases, the price of Squeeth increases as well.
Same as going long plain vanilla call or put, going long Squeeth means long gamma (convexity), long vega (vol), and short theta (time) exposure. As there is no maturity date, theta is represented by a continuous funding fee. Constant gamma that equals 2 provides convexity — you gain more on the way up than lose on the way down. The downside of constant gamma is that it excludes a range of popular options strategies that imply buying low gamma contracts on the expectations of exponential gamma increase as delta approaches 0.5.
Although there is a range of interesting strategies around trading naked Squeeth, it's exciting how this instrument could change the landscape of volatility trading. As discussed above, vol trading is mainly done by professional market makers and was practically non-existent in DeFi before Ribbon pioneered it. So let's see how Squeeth could take DeFi vol trading to the next level.
Consider the strategy of simultaneously going short squeeth and long 2 ether. At the origination of the trade, the position is fully delta hedged, while shorting Squeeth implies positive carry through the funding fee. If realized volatility is lower than implied for a holding period, the position will generate yield. As time passes, a rebalancing will be necessary to keep the delta exposure neutral. It sounds very similar to Ribbon's short vol vaults, but it provides much greater flexibility of being in and out and taking advantage of imperfect market conditions. This strategy will have a similar payoff to a short straddle, which implies going short both call and put with the same time to maturity and strike price.
With Squeeth, one can not only short vol but also long it just reversing the position. Instead of going short Squeeth, one can long it and sell short 2 ether. The position is again delta hedged at origination, and if realized vol will be higher than was implied, the trade will be profitable. Just as going long naked Squeeth, this would be a negative carry position. This strategy will be more challenging to implement in a capital-efficient manner as ether needs to be put as collateral and not USDC, but possible.
As you can see, volatility trading was possible before Ribbon and Squeeth but required a certain experience in options trading and sufficient liquidity. As Ribbon brought relatively sophisticated strategies to a mass audience, Squeeth can extend a range of possible strategies around vol trading.
While spot and futures are well-established niches of crypto trading, options and volatility trading are only getting shaped in the DeFi space. The design of platforms and new instruments are being invented and developed as you read this article — it's an exciting space to follow and contribute. Instruments like AMMs and perpetuals swaps didn't exist in traditional finance but in crypto have $trillions of cumulative trading volumes. So there is a good chance that new financial instruments, whether it's going to be Squeeth or something else, will disrupt the market of DeFi options and volatility trading just like its predecessors.