Published on: 17 Aug 2023Last edit: 06 Nov 2023
Everything you need to know about on-chain options
Options trading has flexibility and risk management capabilities, options have long been a staple in the traditional finance. Its adaptability, coupled with cost-effectiveness and potential for high returns, makes it a favored choice for many. However, it's essential to approach it with caution, understanding the inherent risks, especially concerning leverage and liquidity.
Introduction
Options are a type of derivative contract that gives its purchaser the right to buy or sell an underlying asset at a set price at (or, in some cases, before) an expiration date. These options can be settled in cash or in crypto (Bitcoin or Ethereum). There are two styles of options: American and European. American options allow the buyer to exercise the contract at any time before the expiry date, while European options can only be exercised on the expiry date.
Options can offer investors a relatively low-cost and low-risk solution for trading digital assets compared to trading crypto futures or perpetual swaps. They should be used to protect against price volatility and for risk management, as they allow traders to limit their losses to the premium paid for the option. Currently options are mostly used to speculate as they can lead to extreme gains or losses. The world’s largest crypto options platform, Deribit, is a centralized exchange and settles crypto options contracts in cash. In contrast, decentralized on-chain options, such as those offered by Hegic and Premia, provide 24/7 global trading, verified on-chain settlement of each option contract, and the ability to choose any strike price for WBTC or ETH call or put options.
As more crypto speculators flock towards DEXs rather than centralized exchanges for perpetuals and futures, the same will eventually happend for options. As options trading becomes more mainstream and intersects with the world of DeFi and crypto, it's crucial to shed light on this evolving domain. We've decided to write this article to provide readers with a comprehensive understanding of on-chain crypto options, their potential, and the challenges they face.
The Different Types of On-Chain Options
Decentralized on-chain options are pretty much the same as centralized exchange options. Options as we know it are a type of derivative contract that gives its purchaser the right, but not the obligation, to buy or sell an underlying asset at a set price at (or, in some cases, before) an expiration date. These options can be settled in cash or crypto. There are two styles of crypto options: American and European. American options allow the buyer to exercise the contract at any time before the expiry date, while European options can only be exercised on the expiry date.
On-chain options in crypto can be categorized into three types of orders: orderbook-based options, automated market maker (AMM) type, and structured products.
Orderbook-based: This type of on-chain option uses an order book to match buyers and sellers. It allows users to submit two types of orders: a market order or a limit order. Market orders occur when a trader buys or sells at the best market price instantly, thus pairing a buyer with a seller who currently has orders at the top of the order book. A limit order, on the other hand, allows traders to set a specific price at which they want to buy or sell an asset. The order book model is more common in traditional finance, and it allows for more advanced trading methods and unique order types
AMM: This type of on-chain option uses the automated market maker structure like regular Dexes to provide liquidity for traders buying and selling crypto assets. Instead of trading directly with other people as with a traditional order book. AMMs use liquidity pools to determine the price of an asset, and the price is determined by a constant mathematical formula. Liquidity pools can be optimized for different purposes, and they are currently an important instrument in the DeFi ecosystem.
Structured products: This type of on-chain option uses multiple crypto assets and derivatives to create a unique structure. In crypto, structured products are primarily dominated by option-based products. They are used to protect against price volatility and speculate on market moves. Different types of structured products exist for different market conditions like in a bull market, bear market or the current crab market conditions. Some examples of structured products in crypto are Decentralized Options Vaults (DOVs) and Theta Vaults.
The Potential market for On chain options
Deribit is the biggest market for crypto options market, with a 24-hour trading volume over $500 million . Its 24-hour open interest is also over $1 billion. Such dominance highlights the vast potential for on-chain options in crypto to secure a substantial market share.
Currently, the estimated market size for on-chain options is no where near the size of Deribit, with projects on Ethereum, Arbitrum, and Solana having most of the option volume on chain. In contrast to their centralized counterparts, on-chain options offer a decentralized and non-custodial method for trading digital assets. This approach is a departure from centralized exchanges, which, under their governance, often hold users' funds indirectly.
In the broader context of traditional finance, the TradFi options market significantly overshadows its crypto equivalent. For perspective, stock options trading on the Chicago Board Options Exchange (CBOE) constitutes roughly 20% of the S&P 500's market cap. Meanwhile, Bitcoin options trading makes up maybe 2% of the open derivatives contracts across crypto exchanges. This shows the immense opportunity awaiting on-chain crypto options, suggesting they might bridge this gap in the near future.
The best crypto options trading platform
Options can often be quite challenging, especially in the volatile crypto space. If you're looking for the best place to trade crypto options, Premia Finance steps in to bridge this gap by presenting a Crypto Option trading platform, simplifying the avenue of where to trade crypto options. Not only does it provide a platform for traders, but it also extends its arms to novices with some of the best educational resources, making it a contender for the title of the best crypto options trading platform.
Premia's initiative to marry practical trading solutions with educational support makes it the best choice for individuals scouting the best place to trade crypto options. Read our full deep dive into Premia Finance.
The highs and lows of options
On-chain crypto options are carving their own niche in DeFi, bringing to the table benefits like decentralization, non-custodial trading, and guaranteed on-chain settlements. Yet, they grapple with challenges like limited liquidity, risks for liquidity providers, and potential pricing issues. Additionally, the allure of their speed is sometimes offset by occasional higher fees and processing delays compared to off-chain methods.
Delving into options trading reveals numerous advantes traders and investors. Options are, allowing for the creation of complex strategies that can be lucrative under various market conditions. They're invaluable for risk management, offering ways to maneuver through stock movements, time decay, and volatility. The nature of options as derivatives means they don't represent actual ownership, making them cost-effective. Their potential for impressive short-term returns, coupled with the ability to design unique market strategies, adds to their charm. Plus, their minimal capital requirements make them accessible to the widest range of users.
However, options trading isn't without its challenges. The contracts come with an expiration, setting a deadline for traders. Sellers might find themselves on the wrong side of unlimited losses if the market doesn't favor them. The benefits of high leverage can be a double-edged sword, amplifying both profits and losses. Liquidity can be a concern for certain options especially in the current crypto conditions. Low liquidity will hinder smooth entry or exit at desired prices.
Final Thoughts
The world of on-chain crypto options is undeniably dynamic, offering a fresh perspective on traditional financial instruments. With their decentralized nature, rapid settlements, and enhanced anonymity, they present a promising alternative to conventional trading methods. Yet, like all financial instruments, they come with their set of challenges, from liquidity concerns to potential pricing discrepancies.
As the crypto landscape continues to evolve, it's clear that on-chain options will play a significant role in shaping the future of digital asset trading. Their potential to bridge the gap between traditional finance and the burgeoning world of crypto is immense. Investors and traders alike should stay informed, understand the nuances, and tread wisely in this rapidly changing environment.
Disclaimer: Nothing on this site should be construed as a financial investment recommendation. It’s important to understand that investing is a high-risk activity. Investments expose money to potential loss.
