December 9, 2022
This article examines the common design of existing dual investment products across CeFi platforms and DeFi Option Vaults (DOVs) and explains why such design has limitations and may not be a good choice in a bear market. We further propose an alternative that is more suitable for the current environment.
Dual investments are popular strategies in both CeFi and DeFi for yield enhancement. Crypto platforms, such as Matrixport and Binance, and DeFi option vaults (DOVs), such as Ribbon Finance, offer such products which consist of selling a vanilla call or a put option while simultaneously being long the underlying (in the case of selling a call) or USD (in the case of selling a put). Users can potentially earn a high yield as they sell the optionality embedded in such products.
When a user invests in a dual investment product involving the sale of a call option, it is usually required that the user deposits in the same underlying token. For example, a user must deposit BTC if he’s looking to sell BTC call options. Such design is to ensure that the user can always cover his option obligations and will not default on the options he sold in any possible scenario.
To understand this point, let’s imagine a user who deposits USD 20,000 instead of BTC to sell a BTC call option with a strike price at 20,000. If the BTC price was at 30,000 at maturity, the user would lose 30,000 - 20,000 = USD 10,000 and she would still have USD 10,000 left of her deposit; if the BTC price was at 40,000, the user would lose 40,000 - 20,000 = USD 20,000 which is her entire deposit; and if the BTC price was anywhere above 40,000, the user would lose more than what she initially deposited and her net asset value would go negative.
Now, if the user deposited BTC, she would never be in such a situation. If BTC was above the strike price at maturity, her BTC deposit would simply be converted to USD at the strike price. Even if the BTC price went to 100,000, she would still just need to exchange 1 BTC for USD 20,000. She would miss out on the big rally, but her net asset value would never go under water.
This is why most CeFi platforms and DOVs have made their call-selling products only available to depositors in the underlying token, e.g. BTC, and similarly their put-selling products available to USD depositors. If a user wants to sell calls, she must deposit BTC and if she wants to sell puts, she must deposit USD. By imposing such restrictions, platforms and vaults avoid any situation where they need to liquidate a user’s position since the value of the deposit will never be lower than the maximum option payout.
However, such limitations have a flaw which may hurt users’ returns in a bear market.
Selling call options on its own could be a good strategy in a falling market, but it may not be the best strategy if you have to hold the underlying token of which you believe the price will fall. As discussed above, existing dual investments require that you hold BTC to be able to sell BTC call options. The option may expire worthless if the price goes down, which works out for you on selling the call option, but the value of your deposit, which is in the same token, will go down as the market falls.
Strategy in a bear market
The best strategy in a bear market is probably a combination of holding USD and selling call options. If the price fell, the value of your principal would be preserved in USD and you would make gains from selling the call options. However, such a combination is currently unavailable as existing dual investment products require that you deposit the underlying token, not USD.
Is there a way to make sure the option payoff cannot be greater than the value of the deposit in USD? Yes, there is an easy fix. Instead of a single call option, the product can employ a so-called “call spread” strategy, which consists of simultaneously selling a call option with a lower strike price and buying a call option with a higher strike price. For example, you can sell a call option with a strike at 20,000 and buy a call option with a strike at 40,000. In this way, your maximum loss is capped at the amount of your USD deposit. The advantage of such a tweak is that you can sell call options while owning USD, rather than the underlying token.
With no sign that a raging bull market will come back anytime soon, providers of dual investment products, whether CeFi platforms or DOVs, should consider adding new variations to their existing offerings so that users can pick any combination that best suits their views and objectives.