Writing DeFi Options
What are Writing Options?
Options trading options requires two parties a buyer, who opens a call or put contract, and a seller, known as the writer of the option contract. For a trader to open a position there must be a writer on the other end of the trade who is willing to sell the option. In exchange for writing the option, the buyer pays a fee to the seller, which is called the ‘premium’. The longer the expiration time is, the higher the premium. This is known as the ‘time value’ of the option. The strike price of the option is also part of determining the option premium. A strike price that is closer to the market price will demand a higher premium than a strike price that is further away from the market price.
Traders who write options do so looking to collect the premiums paid by the buyer. Upon expiration of the options contract, if the option is not exercised, the writer keeps the premium as profit. Writing options in traditional over the counter (OTC) markets come in two flavors, Naked and Covered. A Naked Write is when the writer sells an option for an asset they don’t own. Covered option writing is when the writer owns the underlying asset.
Writing options in traditional finance markets can be complicated, and requires depositing money with a broker and trading on a centralized exchange. Traders looking to write options for income can also be required to maintain a margin account with funds to cover any margin calls. The margin requirement can change daily depending on market volatility. If the trader fails to deposit additional funds to cover a margin call the account will enter liquidation.
Risq Protocol has made the process of writing options as simple as possible without dealing with margin requirements. First Risq Protocol DeFi options only allows for covered option writing, all open positions must be backed 100% by the underlying cryptocurrency. We have adopted an AMM (Automated Market Maker) model to options writing. Using liquidity pools (LP), traders don’t have to make a market in a particular strike price. Instead, they only need to join the pool by locking the tokens they want to for writing options for. There are never any margin calls to deal with or KYC needed to start earning premiums.
How are the Options Priced?
Pricing formula for put options: premium = sqrt(period) IV strike / price.
Pricing formula for call options: premium = sqrt(period) IV price / strike.
How Liquidity Pools Work
Liquidity pools are smart contacts that allow traders and investors to deposit tokens for the purpose of making a market in a particular cryptocurrency. The most wildly used liquidity pools are those used on decentralized exchanges such as pancakeswap or sushiswap where a pair of tokens are deposited for the sake of market making. A small percentage of the trading fees are given to the liquidity providers as a reward.
Risq Protocol option pools differ in that only one token is deposited and is then locked for fourteen days to maintain a stable trading environment. When a new option contract is opened the corresponding size of the contract is also locked. When the contract expires the tokens are once again available for writing more options.
As an example, lets say there are 10 ETH deposited to the Risq ETH pool smart contract. Ten ETH options can now be bought. If someone opens 2 ETH Call options with an expiration of one week, then 2 ETH are locked for this one week period to cover the options. Eight ETH are now left available to write more contracts. If during this two-week period a trader tries to place an order for 10 ETH options the transaction will fail since there are not enough ETH available to cover the options. Only orders sizes of 8 contract or less will successfully create the new open position. Once the 2 options expire the 2 ETH is available once again to act as collateral for writing new covered options.
Risq Protocol is about being able to manage risk. Using liquidity pools helps manage risk to option writers by spreading the risk to all pool members instead of the option writer taking on 100% of the risk as on traditional OTC markets.
Earning Yields
Yield farming for earning passive income has been extremely popular with platforms such as SushiSwap, AAVE, COMP and others. Option writers on Risq Protocol earn premiums when options expire. Earnings are paid in the same token they have locked in the pool, meaning that if a writer deposits BCH to the Risq BCH Pool to write BCH options they will earn premiums in BCH.
When making deposits to liquidity pools writeTokens are given, writeBCH is given for BCH deposits and writeCAKE is given for providing CAKE and so on. In addition, new staking contracts for writeTokens will be available soon that earn LP’s small amounts of $RISQ for providing liquidity.
RISK DISCLAIMER: There are significant risks in providing liquidity to Risq Protocol that may outweigh the amount paid to cover the risk (premiums) and/or the current RISQ incentive program. Please make sure to learn how to manage the LP system before you become an LP.
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