Paradigm Insights | Best Practices for Building Decentralized Option Vaults - Pt 1

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October 4, 2022


Decentralized Options Vaults (DOVs) are structured products offered on-chain, closely related to TradFi counterparts that combine several financial instruments to create a whole new payoff curve. The core function of DOVs is to use investors’ capital and employ options trading strategies in a completely automated and decentralized manner. These strategies may include covered calls, protective puts, or straddles. Before DOVs, option strategies were only available to accredited investors through over-the-counter (OTC) trading or by self-execution on option exchanges like Deribit or FTX.

DOVs allow their investors to earn true return on investment (ROI), not just passive income from liquidity provision. The capital is being actively invested in trading strategies, and is independent of the amount of trading being conducted i.e. there is no token “yield” in the traditional DeFi sense. From scratch, DOVs have grown exponentially to become the dominant part of the ~$1 Billion DeFi option TVL, with notionals trading in billions of dollars every month.

Image source: Ledger Prime

Over the past several months, DeFi ecosystems across different blockchains have witnessed a massive surge in new projects focused on structured product vaults with the objective of offering users sustainable yield. Given the infancy of these popular products, we aim to define some very basic suggestions on what a builder must keep in mind while launching DOVs. We aim to critically analyze core functionality behind DOVs, from the trading strategies used to the technology behind the vaults, and how we believe these vaults can be improved.

How do DOVs Work?

As mentioned previously, DOVs allow investors to deposit capital and then automatically trade popular options strategies with it. The most common options strategies employed by DOVs include covered calls and protective puts. Let’s look at these strategies in greater detail. 

Through a covered call strategy, when vault sells a call option, it will also own the underlying security for that option. Similarly, through a protective put, when a vault sells a put option it will also sell the underlying security for that option. Let’s explore this in greater detail below.

Selling Covered Call Options vs Selling Put Options

Let’s first look at the two of the most popular option writing strategies: selling covered calls and selling puts. A covered call is a financial strategy wherein the investor selling a call option owns an equivalent amount of the underlying security. This strategy can be created by holding a long position (spot) on an asset and then selling call options on that same asset to generate an income stream. This strategy entails very low risk as the investor's ownership of the underlying can serve as a cover if the call option expires in the money and the buyer of the call option chooses to exercise. DOV users have a choice to choose either covered call or covered put strategy. If the user feels bearish, they can opt-in for the covered call position and earn yield as the market goes down. Vice versa for users who feel bullish, they can opt for the covered put option to earn yield. Let’s take a deeper dive into the two:

Selling a covered call

By selling a call option, you have the obligation to deliver the asset (e.g. ETH) at a predetermined price (strike price) to the option buyer if they exercise the option.

- If the seller of the call option also owns the underlying security (fully collateralized), the option is considered "covered" because they can deliver the instrument without purchasing it on the open market at possibly unfavorable pricing. Writing call options should be the same size as the underlying long position. For example, if you own 1 ETH, you can sell 1 covered call option. Owning the underlying asset is necessary because selling naked call options without owning the underlying asset exposes the options writer to unlimited risk.

- A covered call will limit the trader’s potential upside profit, capping gains above the strike price. For example, if you sell a call option with a strike price of $2,000, you are giving away profit of the underlying asset above $2,000.

- The goal of selling a covered call option is for the option to expire worthless, allowing the trader to earn the option’s premium while keeping 100% of the underlying asset as collateral

- A covered call serves as a short-term hedge on a long stock position and allows investors to earn income via the premium received for writing the option. Covered call selling typically does well during choppy or bearish environments as the spot price is unlikely to breach the call strike.

- Covered calls should be fully collateralized so that the risk does not come from selling the option as it is covered by the crypto the writer owns.

- If strike price < market price and it is fully collateralized -> writer still makes option premium + gains on holding the crypto.

- If strike price < market price and it is half/not collateralized -> then if crypto assets rocket in price, loss can potentially be unlimited.

Selling a put option

- By selling a put option, you have the obligation to buy the asset (e.g. ETH) at a predetermined price (strike price) from the option buyer if they exercise the option

- Selling a put is an options strategy used to generate yield (income) when traders believe the underlying asset price is unlikely to fall below the strike price before the expiration date

- Note that the writer of a put option will lose money on the trade if the price of the underlying asset drops below the strike price at expiration

- The goal of selling a put option is for the option to expire worthless, allowing the trader to earn the option’s premium while keeping 100% of their collateral

Part II coming next week

This research article is authored by Polygon DeFi researchers: Eshana, Akhil, and 0xlol in association with Paradigm Trading. Eshana is a quantitative finance research intern at Polygon, and is a finance and computer science major at NYU. Akhil is a DeFi research intern at Polygon, and studies finance, math and computer science at NYU Stern. 0xlol (Twitter, Github) heads DeFi research communications at Polygon, with their research interests in DeFi derivatives, Web3 Infra, and Layer 2 Scaling Solutions.

Article by
Polygon Technology

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