The Good Tech Companies - Neverending Options: Trading Options To Infinity And Beyond

Starting point is 00:00:00 This audio is presented by Hacker Noon, where anyone can learn anything about any technology. Never-ending options. Trading options to infinity and beyond, by 2077 Research. Explore the evolution of crypto options and perpetual futures, including innovations like PEN options, and the challenges of liquidity and decentralization. Crypto was born to disrupt the financial world, and it has, albeit not in the way Satoshi Nakamoto intended. In becoming so much more, it grew into a massive playground for speculation. Traders weren't satisfied with spot trading and turned their eyes to derivatives like futures and options. In this article, we break down options, how they differ from futures and the

Starting point is 00:00:41 evolution of perpetual options on centralized and decentralized exchanges. We also examine flaws and challenges and speculate on what the future holds. Siddhite, and let's dive in, futures. A futures contract is an agreement between two parties to buy, sell a certain asset, the underlying, at a given time in the future. At first, futures we reinvented to hedge risks associated with commodities like soy, crude oil, or gold. A seller can set a price before they can deliver the underlying and let the buyer assume some of the risks. Since you don't get the underlying when you sign the contract, you don't have to pay the full price. Instead, a deposit qual to a portion of your position's value is all you need to keep this contract valid. Therefore, you can sign a futures contract worth $100 with only $10 and if the price goes up by

Starting point is 00:01:30 10% to $110, you will get a 100% profit, $10. Such is the power of leverage and is ideal for crypto investors seeking to amplify their returns. Eventually, someone realized you don't have to deliver the product at a Givant team because cryptocurrencies will always be there. A futures contract that never expires looks tempting to anyone seeking 100x their investments. There is one caveat, though. Since Satoshi Nakamoto released his famous white paper, the overwhelming majority of the crypto community has been longing cryptocurrencies. As a consequence, the futures market will be dominated by buyers, moving the futures price ridiculously higher than its spot price. Traditional futures contracts also have this problem but the market has a way to manage it. These contracts expire, so any deviation between the futures price and the spot

Starting point is 00:02:21 price gradually disappears as the expiry date approaches. It happens because the difference between buying on the futures market and the spot market becomes smaller over time. The same can not be said for perpetual futures. Now that they don't expire, we may never see the day when the basis disappears. Something must be done. For the record, we don't know what happened when BitMEX invented perpetual futures but since these contracts are sometimes referred to as perpetual swaps, one can only assume that they decided to borrow a mechanism from swap contracts and agreement between two parties to exchange cash flow, typically used to hedge the risk of oscillating loan interest rates or to exchange value between two positions. With this mechanism, perpetual futures buyers and sellers must exchange

Starting point is 00:03:04 cash flow, making funding payments, with each other based on the difference between the underlying's futures price and spot price. If the futures price is higher, the underlying trading at a premium, the buyers have outbought the sellers. At such times, the funding rate mechanism dictates buyers must pay sellers based on their position size. This way, sellers will have enough reason to hold on to their short positions and buyers will have their accounts bled dry if they keep their long positions open indefinitely. Options. The reason we spent hundreds of words talking about perpetual futures in an article dedicated to options is that we wish to demonstrate how removing a seemingly insignificant variable, expiry date, from a financial instrument could lead to starking imbalances in the market and take some of the

Starting point is 00:03:48 most innovative minds to fix it by introducing a new mechanism. Understanding options Options are quite like futures, except futures contracts impose on both parties the obligation to transact a certain asset at a given time, whereas options only give them the right. You have the option to pocket your profit when you're optionized in the money, ITM, as well as throw it into the bin when it's out of the money, OTM. As such, futures contracts can be priced based on their entry price but options must charge a premium for signing this contract. This premium is the price a buyer pays a seller, writer, and options at each price tick form a market on their own. Buyers are free to choose the lowest ask they can find for a certain underlying at a certain

Starting point is 00:04:30 strike price. Once again, removing one restraint, obligation to buy or sell, from a financial instrument leads to an entirely different derivative. Traditional options already give investors immense flexibility for locking profits and hedging risks. You can hold a long position for an underlying while buying a put option of the same size for the same underlying at the same price. This way, if the price goes down, your long position is at a loss but the amount is only equal to your profit from the put option, or its seller, leaving you losing only the premium you paid for your put. If the price goes up, your long position stands to profit and you can throw your OTM put option in the bin.

Starting point is 00:05:10 As you have seen, even options that expire are already much more complex than futures. Black, Scholes, and Merton won a Nobel Prize for developing a formula for stock options valuation. But what if we take it a step further and remove the expiry date from the options, like what we did to futures, path dependency? There are two approaches that have our attention. One was proposed by Paradigm and the notorious Sam Bankman fried in their research titled Everlasting Options and the other by Panoptic. Everlasting Options. A universal funding model for efficient liquidity and our bid rage in this paper. The authors proposed a universal funding mechanism for derivatives based on the difference between mark price and index price of the underlying, for futures,

Starting point is 00:05:52 or the contract itself, for options. This is a generalized version of the perpetual futures funding mechanism and backed by Fino arbitrage pricing model that where there is a potential profit, there will bear bidtragers to make the most of it. In the case of perpetual futures, buyers will pay sellers when the mark price is higher than the spot price or in the case of everlasting options, when the mark price is higher than the potential payoff. This universal mechanism is playing the arbitrogers and such activities are ideal for centralized exchanges since the calculations and payments can be made within milliseconds by their complex trading engine running on mega servers. Indeed, the authors mentioned the traditional crypto options market being a nightmare, in our own words, for market

Starting point is 00:06:34 makers because there are just so many markets to make. Their everlasting options are equivalent to a basket of options with different expiration times and weights equal to the inverse of 2 to the power of the number of funding cycles before the expiration time. This way, market makers can concentrate their liquidity on these baskets instead of spreading it on 100 markets. But the thing is, no one said options can only be traded on centralized exchanges with large institutions as market makers, liquidity providers. 8. Centralized ecosystem calls for decentralized protocols and mechanisms that are less costly and cumbersome for smart contracts. P-A-N-O-P-T-I-O-N-S. A Uniswap-inspired, Oracle-free revolution enter Panoptic with

Starting point is 00:07:17 their perpetual options, Panoptions. By comparing a put option to a Uniswap V3 liquidity pool, they propose this on-chain option that never expires. Uniswap V3 liquidity pool, they propose this on-chain option that never expires. Uniswap V3 pools allow liquidity providers to deposit two assets and earn fees when the price ratio between these two assets is within a certain range. When it's out of the range, your liquidity becomes 100% of the asset with the lower price. Panoptic put options are essentially concentrated liquidity deployed on a single price point, its strike price. Let's pretend you hold an ETH USDT panoptic put option. When ETH's price goes above the strike price, this put option is OTM and becomes 100% USDT.

Starting point is 00:07:59 When ETH's price is below the strike price, the buyer can give 1 ETH to the seller in exchange for all the USDT in the pool, earning the difference between the strike price, the buyer can give 1 ETH to the seller in exchange for all the USDT in the pool, earning the difference between the strike price and the price they paid for that 1 ETH. Panoptic call options work exactly the same except the two assets must switch places. But that's only half the formula. We still need to price the panoptions by putting a premium on them. In contrast to traditional options, panoptions charge a no premium upfront and assume that the value of options can be realized over time. Meet theta, a Greek letter used to define the rate of an option's value decline over time.

Starting point is 00:08:35 If you studied derivatives, the mathematical one, you would know the derivative of mileage over time is velocity, the rate, speed of your mileage increase over time. And by integrating the speed over time, you get mileage. Theoretically, the same goes for options. If we integrate theta, the value speed over time, we get value. We are able to do this because there is another formula for theta instead of doing derivatives. Where S denotes the underlying asset spot, or current, price. Sigma is the asset's volatility, K is the strike price, and T is the time to expiration. Note this formula is flawed since we assumed a zero risk-free interest rate when in reality it can get quite higher.

Starting point is 00:09:16 But how high should we take the interest rate from Binance Earn, ETH Staking, Aave Lend, or heaven forbid, treasury bonds? This question may take an industry to answer. The good news is, we still haven't said a word about oracles because by tethering pen options to the corresponding Uniswap v3 pool, this system won't ever need an oracle as long as there are enough traders swapping tokens via this pool. This way, we have a simulated option on smart contracts, a premium that is price path dependent but oracle free, and some solid knowledge in derivatives, both financial and mathematical. We are probably more ready than 99.9% of individuals on earth to trade options. Perpetual options on chain,

Starting point is 00:09:57 Panoptic built an entire options trading ecosystem with smart contracts. Participants are divided into liquidity providers, option sellers, and option buyers. Before anyone can do anything, liquidity providers must first deposit a setting to a liquidity pool. Sellers and buyers must also deposit their collateral. Sellers need to first mint their call or put option by paying a 0.1% commission and locking up, borrowing, a certain amount of liquidity at a strike price. Then, buyers can buy these options by paying the same rate of commission, locking up some more liquidity, and minting their position.

Starting point is 00:10:33 Since our premium is accumulated over time, there should be zero premium when the option was just sold. Instead, sellers would be credited a streaming premium every time the spot price crosses the strike price. When exercising their options, buyers will pay back their borrowed liquidity plus premium while getting the numeraire for put options or the underlying asset for call options. On one hand, Panoptions is genius. By synthesizing options with Uniswap v3 PoolSand settling premium when the option is exercised, the entire process is moved

Starting point is 00:11:05 onto the blockchain. Anyone can access these financial instruments as long as they know their way around wallets and smart contracts. Under the ERC-1155 token standard, you can mint several options into one token for further risk and volatility customization or even duplicate a composition someone else just shared. On the other hand, since PAN options can be minted at zero premium and a 0.1% fee, who's to stop arbitrageurs from buying ITM options before immediately exercising them for guaranteed profit? After a few costly lessons, who's to encourage sellers into minting ITM positions only to lose money? With only OTM options, the market will be as bustling as an empty bucket. Finding the F law in funding and finance. That's not to say the

Starting point is 00:11:52 centralized approach has no flaw. The universal funding mechanism can be perfect if the funding is calculated and implemented every nanosecond. But when the funding cycle is stretched to 8 hours, a lot of things can happen right before and after funding payments are made. People may open apposition 0.01 seconds before funding and close it immediately after receiving funding payments, leading to abnormal fluctuations around the time of funding. If we take a step back, the funding mechanism is merely a band-aid slapped onto someone with a headache that has CEX-traded crypto options. The real hurdle that is holding so many exchanges back from introducing options is the lack of

Starting point is 00:12:30 liquidity. When you first look at it, crypto options seem a good instrument boasting similar open interest to perpetual futures. When in reality, the options market is divided into hundreds of sub-markets, each with a different expiration, strike price, and supply and demand. As a result, liquidity is fragmented into dozens of pieces and the spread on some sub-markets can be jaw-dropping. And that's just Bitcoin. Go to Bybit, the second, third CEX, and look for options for Solana, the fourth largest crypto. Not counting stablecoins, looking to surpass Ether, you'll find almost half of the sub-markets empty. Options are just too complex for investors without a systematic understanding

Starting point is 00:13:11 of finance and investing, at least at first glance. It's not even friendly to market makers, as mentioned in path dependency. Looks like we must educate all traders about the benefits of options and invite them to trade these fine instruments. Markets can be made as long as there are enough traders. But that's just another band-aid on an even grimmer headache. If you're looking to trade crypto derivatives, there are two places to go. CEX and DEX. CEXs are generally faster with more liquidity but you must go through an arduous KYC process and put your funds in the hands of others. DEXs give you more control and freedom but are not nearly as fast or efficient as CEXs. At its current state, blockchain will never be an ideal place for sophisticated OR institutional traders commanding huge liquidity who would choose speed-overed centralization and

Starting point is 00:14:00 permissionlessness any day. Many DEXs will look to centralize one or several links in their protocol such as order book, order matching engine, database, market makers and more to maximize efficiency and attract large institutions with deep pockets. As a result, centralized institutions will have more and more say in these protocols and in the end, they may just turn into on-chain CEXs where decentralization is nothing but a name. Such is the finance industry. When even the slightest edge may put you ahead and rake in billions of dollars, the survivors will look to build higher and higher walls and work with players from all walks to protect their interests. To a newcomer, the world of finance is as much a

Starting point is 00:14:40 dark forest as Ethereum is although neither was designed to be initially. Uninitiated individuals will always get eaten alive in such a hostile environment while the survivors feed on their remains and grow into behemoths that are too big to fall. In the end, these financial giants will have immense fun playing with sophisticated, quadruple-synthesized products like MBS in an extremely centralized walled garden while the outsiders will do anything for an entry pass. Satoshi Nakamoto did invent Bitcoin to battle centralization but now, the cryptocurrencies may just become another place where institutions take an individual's funds and throw them one or two bones every now and then. A look into the future.

Starting point is 00:15:19 But the future is not all doom and gloom. There surely will be more brilliant minds trying to innovate on perpetual options and evangelizing this financial instrument. Options that favor long-term investors with minimal arbitraging opportunities may be invented and blockchain is just an ideal place for them. Account abstraction may eventually bring in hundreds of millions of new users and with them, fragmented liquidity may not be a problem anymore. Traders who value decentralization and privacy will still get to play and grow their own games. A few boutique protocols may survive through the years and eventually be discovered by the masses. Looking back, perpetual options may

Starting point is 00:15:57 not even be the right answer we are looking for. They are one of the most important derivatives with a spark of crypto innovation but at its current state, it's merely a derivation from a traditional financial instrument that is as far from decentralization as an empty bucket. To disrupt the old finance, we may need to build a new one from the ground up. A version of this article was originally published here. Thank you for listening to this HackerNoon story, read by Artificial Intelligence. Visit HackerNoon.com to read, write, learn and publish.

The Good Tech Companies - Neverending Options: Trading Options To Infinity And Beyond

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.