HomeCoinsAuctus (AUC)Auctus’ Options Mastery Series— Introduction & Basics to DeFi Options | by...

Auctus’ Options Mastery Series— Introduction & Basics to DeFi Options | by Nico Pottebaum | May, 2021

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Since 2017 the Crypto-realm has significantly changed from a world of “whitepaper-dreams” and the following ICO Mania to a whole new world of exciting projects that have the power to change the entire Finance-industry.

In times of Modern Money Theory where central banks can print infinite amounts of money decentralization becomes inevitable. What has begun with the idea of a “purely peer-to-peer version of electronic cash” named Bitcoin in 2009, nowadays widely accepted as the best store of value, rapidly leaded to demand for other Decentralized Finance (DeFi) products like Exchanging value, lending and borrowing value, asset management, inscurance, options and so on. Take a look on the exponential growth in DeFi:

Total Value Locked (USD) in Defi from Oct 2017 till May 2021

Auctus’ Options Mastery is a course which aims to give you a broad overview about all you need to know about options. Starting with the Key Option Terms we will also cover what an option is and how they work, when it makes sense to trade them and last but not least the risks you have to pay attention to before trading options.

  • What is an Option?
  • Why Options?
  • Options Lingo

→ Structure of options

→ Long Call / Put

→ Short Call / Put

  • Risks involved trading options in DeFi

→ Risk in trading options

→ DeFi risks

Options — many investors have heard about them but only a few know how these financial instruments really work. Because of potentially high returns, they attract many investors. Be aware: Higher returns go hand in hand with higher risks.

Options belong to the category of derivatives. The price of an option derives from the price development of its underlying asset. As an underlying asset you can imagine any asset class like bonds, stocks, currencies, commodities. In DeFi and especially with Auctus you can trade options on any ERC-20 Token.

With options you basically trade rights. As a buyer of an option you purchase the right (not the obligation) to buy (Call) or sell (Put) an asset to a fixed price at any time before or at expiration (american style). The seller of an option on the other hand has the obligation to deliver the underlying asset, when the buyer excercises his/her option.

The big advantage options have in contrast to other derivatives like futures is that the buyer of an option purchase the right and not the obligation to excercise his/her option. More to excersising an option later.

Investors and traders buy or sell options for various reasons. First of all options trading allows holding a leveraged position in an asset at a usually lower cost than buying the asset on the market. Also given the volatility in the crypto-space Investors use options as a hedging-tool to reduce the net exposure of their portfolio. On the other hand selling options generates income through collecting premiums, which the holder pays for buying an option.

Given to your individual point of view of how the price of an asset will develop there are various trading-styles you can use to maximize your risk/reward ratio. We will dive into the different options-trading-strategies in another chapter of Auctus’ Options Mastery Series.

  • Options: Options are financial derivatives that give buyers the right (not the obligation) to buy or sell an underlying asset (e.g ETH, BTC, …) at a predetermined price and date. There are two main types of options: Calls and Puts which are the foundation for a wide range of option-trading-strategies designed for hedging, income or speculation.
  • Call Option: the right (not the obligation) to purchase the underlying asset at a specified price at any time before or at expiration. (American-style)
  • Put Option: the right (not the obligation) to sell the underlying asset at a specified price at any time before or at expiration. (America-style)
  • American Style Option: An American Style option allows the holder to exercise the option at any time during the period of validity. All options traded on Auctus are American Style Options.
  • European Style Option: An European Style Option can only be excercised on the date of expiration.
  • Strike price: The Strike price is the set price at which the option can be bought (Call) or sold (Put) when it is exercised.
  • Expiration date: The Expiration date refers to the date in which the option expires and thus the last day that the option contract is valid.
  • Underlying asset: The underlying asset is the financial asset upon a options price is based. The price development of the underlying asset is the main value driver of an option.
  • In-The-Money (ITM): A Call option is ITM when the market price of the underlying asset is greater than the strike price. A Put option is ITM when the market price of the underlying asset is less than the strike price. (see intrinsic value)
  • At-The-Money (ATM): The current price of the underlying asset and the strike price are are identical.
  • Out-The-Money (OTM): A Call option is OTM when the market price of the underlying asset is less than the strike price. A Put option is ITM when the market price of the underlying asset is greater the strike price.
  • Premium: The current market price of an options contract. The premium is the income received from the option buyer. ITM options’ premiums are composed of two factors: intrinsic value and time value. OTM options’ premiums consist solely of time value.
  • Option Writer (Short): The option writer sells the option to a buyer and gets a premium as compensation. The option writer has the obligation to deliver the underlying asset to the agreed upon price, when the buyer excercises his/her option.
  • Option Holder (Long): The Option holder purchase the right to buy or sell an asset and pays a premium for that. In opposite to the option writer the option buyer has not the obligation to excercise the option.
  • Exercise: Excercising an option means to put into effect the right to buy or sell the underlying asset at the predetermined price which is specified in the options contract.
  • Intrinsic Value: (price of underling asset – Strike price ) x amount of options. (Intrinsic Value ≥ 0 !)
  • Time Value: The extrinsic value of an option is based upon the amount of days till expiration. The more time there is before expirtion the higher the time value and thus the more expensive the premium.
  • Bid: The bid price represents the maximum price that a buyer is willing to pay for an option and equals the premium the option writer gets.
  • Ask: The ask price represents the minimum price that a seller is willing to take for an option and equals the premium the option buyer has to pay.
  • Spread: The price difference between buyers and sellers. The smaller the spread the more efficient the market.
Strucure of an AOC option on Auctus

Long Call:

The holder of a call option buys the right (not the obligation) to purchase the underlying asset at a specified price at any time before or at expiration. The buyer of a call option expects rising prices of its underlying asset. The buyer of call option wants to see the market price of the underlying asset greater than the strike price so he/she can buy the asset cheaper and sell it on the market for profit.

The cash out profile of options is asymmetrical. That means the buyer of a call option has the theoretical chance of unlimited return while the loss is capped to the premium he paid:

Pict 1. Profit/Loss chart of 1 ETH Long Call option: AOC ETH-2500-C-23APR21–0800UTC

→ Unlimited upside + maximum risk: 134.2 USDC

Long Put:

The holder of a put-option buys the right (not the obligation) to sell the underlying asset at a specified price at any time before or at expiration. The buyer of a put-option expects falling prices of its underlying asset. The buyer of a put option wants to see the market price below the strike price so he/she can sell the asset at a higher price then he/she could on the market.

Pict 2. Profit/Loss chart of a 1 ETH Long Put option: AOC ETH-2300-P-23APR21–0800UTC

→ Maximum upside: 2300 USDC + maximum risk: 143.3 USDC

You can also sell (short) call options and put options and generate income through collecting premiums.

Short Call:

The writer of a call option has the obligation to sell the underlying asset at a specified price at any time before or at expiration, when the holder exercises the option. The writer of a Short Call option expects stagnating or slow fading prices.

Theoretically the writer of an option has unlimited risk, while the profit is capped to the premium he/she collects from the holder.

Pict 3. Profit/Loss chart of 1 ETH Short Call option: AOC ETH-2500-C-23APR21–0800UTC

→ Maximum upside: 134.2 USDC + maximum risk: unlimited

Short Put:

The writer of a put option has the obligation to buy the underlying asset at a specified price at any time before or at expiration, when the buyer exercises the option. The writer of a Short Put option expects stagnating or slow rising prices.

Pict. 4 Profit/Loss chart of 1 ETH Short Put option: AOC ETH-2800-P-23APR21–0800UTC

→ Maximum upside: 143 USDC + maximum risk: 2800 USDC

Risk in trading options

“There ain’t no such thing as a free lunch

  • Potential losses — Worthless expiry

The majority of options expire worthless. That’s why Warren Buffet for example loves selling covered call options to collect premiums while he waites for his picked stocks to hit certain price points.

  • Unlimited potential risk — selling options

Despite most of options expire worthless there is a chance to of a black swan event you don’t expected and you have the obligation do deliver the underlying asset to the determined strike price not matter what the current market price is. Let’s go back to the example of selling ETH Call options with a strike price of 2500 USDC in the previous chapter. There is a chance of ETH mooning to let’s say 5000 USDC. The holder of the option will definitely excercise the option to buy ETH for 2500 USDC from you. Despite you collected a premium of 134.2 USDC you also reduced your upside significantly.

The prices of options are much more complex to determine because of the various variables which influences the price such as implied Volatility, time till expiration and so on. We will cover the pricing models and the so called “Greeks” in a different chapter.

The Time decay can negatively impact the option price. As we buy an option and the time passes the option price can significantly change to the negative despite the price of the option did not move. This is called time decay.

DeFi risks

Next to the financial risks you take trading options there are some further risks you should know. The knowledge of risks associated with DeFi can give you advantage in their efficient utilization for various goals in the fintech landscape. The following discussion provides you a detailed impression of potential risks related to DeFi that can help in better adoption of DeFi services.

A smart contract enforces the negotiation of an agreement without the need of a middle-men. Settled negotiations (transactions) are stored on the blockchain. Smart contracts are most secure, if the programmer is knowledgeable in this field. But bugs can still be missed and we highly recommend: Always do your own research to ensure if the underlying contract is correct and publicy and independently auditet.

Software risks are also one of the crucial technical risks when it comes to DeFi. The general risks for DeFi software include Distributed Denial of Service or DDoS attacks, injection, uncontrolled format strings, and overflow. DDoS is a credible mention among techniques for disruption of the normal functioning of an app or service.

  • Governance weak spots and Admin Keys

Some DeFi protocols have community governance options in the form of governance tokens. This lets token holders propose and vote on key decisions to be implemented about the platform. Although this puts important decisions in the hands of the community, it also means you should keep track of major changes.

Many DeFi smart contracts are controlled using admin keys. These allow the key holder to make important changes to the code, such as upgrading the protocol. It is common for smart contract administrators to protect their admin keys using advanced security methods, such as multi-signature and time-locks. However, this still means that you are relying on the key holders to take proper care.

If you’d like to learn more about Auctus ($AUC) make sure to visit the official website, join our Discord or Telegram, and give us a follow on Twitter.





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