Created by Jack Ding｜W3.Hitchhiker

An Overview of On-chain Options

At present, there are three main types of on-chain options:

• Orderbook

• DeFi Option Vaults(structured products)

• Auto-market Marker

（resource：https://www.panewslab.com/zh/articledetails/1644045861942159.html）

Orderbook

e.x.：Zeta，Psyoption，Opyn

Option order books also require high tps blockchain to guarantee cheap and fast execution. Opyn used the Orderbook model on ETH main chain, but due to the lack of liquidity and high gas costs，trade volume is very low. Opyn changed its product to develop structured products on January.

On Solana, there are some Orderbook option products such as Zeta Markets and Psyoptions, but due to the lack of enough traders and professional market makers, the bid-ask spread is wide and some prices are priced without market.

DeFi Option Vaults

e.x.：Robbin，Opyn，Thetanuts，StakeDAO，Katana

「DeFi Option Vaults: Options Democratized - Treehouse Insights」

Option strategies are complex and not everyone has the time or knowledge to execute them in a timely manner, so we need DeFi Options Vaults (DOV).

DOV provide users with a way to easily deposit money into predefined options strategies to earn revenue.

「DeFi Option Vaults: Options Democratized - Treehouse Insights」

It exploded in December 2021, when it grew much faster than the DeFi industry as a whole. In three months TVL managed to quadruple its size and is still up 1.5 times from October in a bear market

Now, the main strategy of DOV are covered call and put selling.

Covered call on Robbin

When user deposit one eth, the pool will generate a call option with a strike price of 2050, which will be sold in an auction. if eth price below 2050 when it expires in a week, the users in the pool will earn the option premiums.

In short, it is the possibility of giving up the underlying asset to rise sharply, which is a relatively simple strategy in the option.

Auto-market Maker

e.x.：Lyra，Primitive，Pods，Premia

These products are worth more than DOV, but they are at a disadvantage in terms of market performance. According to defilama data the top two options on TVL right now are OPYN and Robbin. But I believe that as more and more professional investors come to blockchain, the value of these products will grow rapidly.

This article focuses on Lyra which is an options automated market maker (AMM) that allows traders to buy and sell options on cryptocurrencies against a pool of liquidity.

Team

• Michael Spain

Michael Spain - Co-Founder @ Lyra Finance - Crunchbase Person Profile

In 2017, Michael joined SNX as an engineer,one of the core members of SNX.

Michael graduated from the University of Sydney with a double degree in Computer Science and Finance

• Nick Foster

Nick Foster - Co-Founder @ Lyra Finance - Crunchbase Person Profile

Bachelor of Mathematics in Finance, University of Sydney

From 2018 to February 2021 he was an equity trader at Susquehanna International Group, LLP (SIG)

Mechanism Introduced

Basic Concept of Option

Delta

Delta is the price sensitivity of the option to changes in the underlying asset price. If a call option has a delta of 0.5 and the asset rises by $1, the value of the option will increase by $0.50. If you go long 1 delta, you go long one of the underlying assets.

Another way to use delta is to make a rough estimate of the probability that an option will be in the money option at maturity. A 0.5 delta call option means that the asset has approximately a 50% chance of trading above our strike price at expiration.

Vega

Vega is the price sensitivity of an option to changes in asset implied volatility (IV).

Gamma

The second derivative of Delta, which is the sensitivity of the option to changes in the price of the asset underlying delta.

Theta

The theta of an option measures how much value it will lose as a result of the passage of time. The theta is typically quoted as the dollar amount which an option will lose if time is fast-forwarded one day. For example, if the theta of an option is $5.00, the option will be worth $5.00 less in one day's time, assuming all else equal.

Rho

Rho is the rate at which the price of an option changes relative to the risk-free interest rate.

Delta and Vega are the two most important parameters in Lyra, because by managing delta and vega risk, you balance gamma and theta risk. Rho risks are generally much smaller than other risks because the risk-free rate tends to be relatively constant.

Pricing: Black Scholes Model

The key parameter for pricing under BSM is volatility

Lyro calculates the fair value (W) of the option by inputting IV.

IV

There are two parts of IV: baseline and skew ratio

Baseline IV

We can easily know the volatility of underlying asset.

Just like the AMM of DEX, the price will shift when a transaction occurs, and the IV will also shift. At this point, LYRA introduces another parameter, standard size.The standardSize parameter is defined as the number of contracts a trader would have to buy (sell) for the AMM to increase (decrease) the baseline IV level for an expiry by one percentage point. This is the mechanism that allows the AMM to converge to a market-clearing level for IV.

Skew Ratio

Lyra's AMM accounts for volatility smiles by including a strike-specific adjustment to the implied volatility parameter that is used to price options, called the skewRatio.

Skew Ratio includes Strike Volatility Ratios and skew impact parameter

The final implied volatility value that is fed into the Black Scholes pricing model is a combination of the baseIV of the relevant expiry, and the skewRatio of the relevant strike. That is:

tradeVol = baseIV × skewRatio

tradeVol = (IV +- 1%（vol/standard size）) ×（Strike Volatility Ratios +- skew impact parameter ×（vol/standard size））

In my opinion, the first part of the equation is a shift , and the second part is a shift in the slope of the AMM curve

Hedge LP Risk

Vega risk

Vega risk is the risk of option price change caused by the change of underlying asset volatility.

The adjustment is to balance this risk by charging traders a portion of the price around Fair Value

This fee is determined by the VEGA of the pool as a whole, which simply means that the goal of the spread is to charge more for trades that increase the pool's Vega risk and less for trades that hedge its exposure.

Suppose Black Scholes pricing a call option at $100 with a net short of 500 vega in the pool. In this case, AMM might be willing to pay $95 for the call option ($5 fee) but sell it for $110 ($10 fee).

Delta Risk (enabled in V2 version 6.28)

When the trader buys 10 eth call options on lyra, the pool position will be short 10 eth call options. If the delta of this option is 0.5, then the overall delta of the pool will be -5, that is to say, when the spot eth increases by $1, the pool value will decrease by $5

In this case, the pool would have to go to the spot market and go long 0.5*10= 5ETH, changing its delta to 0 to hedge the risk.

Prior to May 27, delta risk was not hedged

In the absence of delta hedges, liquidity providers in option AMMs almost always have exposure to call the underlying asset when the market is weak, which results in large losses for liquidity providers in a market slump.

In the 8th round, for example, liquidity providers lost $1.58 million, including $1.8 million due to a decline in the value of collateral held (delta risk). So if timely hedging is enabled, Lrya does well against Vega risk in extreme markets, removing 1.8 million delta unhedged losses and maintaining a profit of $220,000.

Officials have tested delta hedging for the past eight rounds

We find that if delta hedging is turned on, the majority of the rounds are profitable, and the frequency of hedging depends on how we choose between reducing risk (increasing the number of hedges) and reducing costs (reducing the number of hedges).

Ways to hedge:

The pool is periodically hedged by keeper

Now due to low market activities, officials as keepers internally, but anyone can technically call poolhedge-.hedgedelta ().

All delta hedge calculations are done on-chain.

Transaction fee

Lyra's fee function is made up of three distinct components:

• A flat fee based on the option price

• A flat fee for exchanging costs

• A dynamic fee based on the pool's vega risk

• A dynamic fee based on the difference between the expiry's baseIV and its GWAV, as well as the traded strike's skew ratio and vega.

Summary of trading mechanism

The trader initiates a trade - calculates the change in IV - plugs into the BSM model to calculate the option price - charges the trade based on the pool's Vega risk - adds the fee and spot fee to get the final price - the trade completes the pool to recalculate the Vega and delta

Disadvantages of On-chain Options Market

1. Liquidity segmentation problem: Options in traditional financial markets have different strike prices and strike dates under different underlying assets. Making a pool of each product will obviously split liquidity, so it is necessary to reduce the diversity of parameters (strike price or strike date) when the options market is niche.

2. Decentralized market makers must have hedges. For a pool of liquidity to underwrite options and be able to sell them both ways, you have to hedge. ** Because the pool acts as a counterparty to the net position ** of the entire market, most of the time, especially in a one-sided bull/bear situation, the market have a high degree of consensus on the expectations of the rise and fall, as can be seen from the capital rate of perpetual futures. So how to hedge the lp in the pool is one of the most difficult problems to solve in all option protocols. Because not only does it have to dynamically calculate the risk for its LP and price the options accordingly, it also has to find a way to hedge the risk through spot or futures.

3. High gas charges. Many options are cheap for investors and are particularly sensitive to gas fees. For the project side, it must continuously calculate the option price according to the change of the net position and the underlying asset price, and then hedge the risk exposure of lp.

Lyra solution

1. By setting the range of delta (0.1-0.9), the strike price available to investors is also limited to a range to further reduce the difficulty of pricing calculation

2. Choose to deploy in Optimism, which has lower cost and faster speed for project parties and traders

3. Backed by SNX, there are mature derivatives supporting, which is convenient for lyra to hedge delta risk

Ecological composability

Upstream is the SNX, which provides a hedge pool for a period of time to easily hedge delta risk

Downstream is structured products, such as Robbin's previous strategy, are bound to face the problem of insufficient liquidity in part of the time. LYRA adopts AMM mode to make such structured products directly connect to each other and ensure liquidity

Now Polynomial which is one of DOV on Optimism,is migrating vaults to lyra.

Token Allocation

A total of 1,000,000,000 LYRA have been minted, and will begin to become accessible starting on December 14th, 2021 at 00:00:00 UTC

• 50% (500,000,000 LYRA) to the community as follows:

  • 15% (150,000,000 LYRA**) allocated to Traders**. Trading rewards provide a direct incentive to use Lyra and if implemented effectively, can minimise the fees paid by traders as well as the risks incurred by LPs.

  • 15% (150,000,000 LYRA) allocated to Liquidity Providers. Lyra needs liquidity to facilitate options trading. When options are purchased by traders, collateral must be locked to ensure that the option can be paid out if it expires in the money.

  • 10% (100,000,000 LYRA) allocated to Security Module stakers. The Security Module is designed to secure Lyra's traders and liquidity providers in the event that the protocol becomes insolvent and cannot fulfil its obligations. This will become especially important in V2 when positions are not fully collateralised.

  • 5% (50,000,000 LYRA) allocated to incentivise liquidity in the LYRA token, which will help create a healthy market.

  • 3% (30,000,000 LYRA) allocated to Community Incentives. These incentives are as yet unspecified, and are to be allocated by the Council via the LEAP framework.

  • 2% (20,000,000 LYRA) allocated to SNX stakers. Specifically, those who stake SNX on Optimism. This provides a strong incentive for stakers to move over and increase the sUSD supply, which Lyra relies on for trading/LP functionality.

• 20% (200,000,000 LYRA) allocated to the LyraDAO. The DAO aims to ensure the ongoing development of the Lyra Protocol and the general growth of the Lyra ecosystem.

• 20% (200,000,000 LYRA) allocated to the core team. This is enough to ensure long-term incentive alignment whilst allowing the community to own the majority of the project. In almost all cases, tokens are locked for six months from the contributors start date and then vest linearly over two years. The vast majority of team tokens (>19%) unlock between January 1 2022 and January 1 2024.

• 10% (100,000,000 LYRA) were sold to private investors.

• Private Investment Disclosures:

  • Pre-seed: In February, 3.4% of the supply was sold at a $15M FDV, implying a token price of $0.015. These tokens were sold from the investor allocation.

  • Seed: In May, 6.6% of the supply was sold at a $50M FDV, implying a token price of $0.05. These tokens were sold from the investor allocation.

  • OTC: In September, 0.5% of the supply was sold at a $100M FDV, implying a token price of $0.10. These tokens were sold from the DAO allocation.

  • All private investor tokens are locked until January 1 2022 and then vest linearly over two years, with the final tokens unlocking on January 1 2024.

Financing

2021.7.26, Lyra announces the completion of a $3.3 million funding round. The round was co-led by Framework Ventures and ParaFi Capital.

DeFi Alliance, Divergence, Orthogonal, Robot Ventures, Apollo Capital, Magnet Capital, and Kain, founder of individual investor Synthetix Warwick and co-founders Jordan Momtazi and Jinglan Wang, Aave founder Stani Kulechov, Bankless founder Ryan Sean Adams and others participated in the investment.

The financing will be used to hire staff and expand the engineering team.

The investment institutions are all leading institutions in the field of defi, but the amount of financing is relatively low

Two founders of SNX, Jordan and Kain, are involved in the investment

Jinlan Wang, founder and CEO of Modernism, participates in investing

Summary

Advantage：

1. From the perspective of market positioning, the option trading volume in the traditional financial market has been greater than the spot trading volume, while the crypto option market is currently in the early stage, and the on-chain option is currently in the early exploration stage, with huge space for imagination

2. From the perspective of mechanism design, its option AMM mechanism is a great attempt, which provides the possibility of option trading for long-tail assets in the future.

Disadvantage：

1. Can only do delta 0.1-0.9 option, limited choice

2. At present, due to the lack of liquidity, we can only do eth options, and it has just been transferred to V2. The current liquidity is only 10 + million, and the bid-ask spread reaches $4-8

3. The newly added delta hedge has not been tested by the market.

4. At present, the project itself plays the role of keeper (balance delta risk), and the overall market participation is low

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