Author: Grix, translated by: Shanooba, LianGuai
Options trading is the cornerstone of the traditional financial world, and it has been adopted and transformed by the emerging decentralized financial world. Their strategic applications can provide complex risk management, revenue generation, and speculative profit opportunities, while leveraging the unique qualities provided by DeFi. Let’s dive in!
Understanding DeFi Options
Options under the DeFi context retain the basic principles of traditional finance: they offer the right to buy or sell assets at a specific price before a specific date, but not the obligation. However, what sets DeFi options apart is the open, permissionless, and trustless nature of their architecture. The democratization of financial services eliminates intermediaries, improves transparency, and creates opportunities for financial inclusivity and innovation. If you want to deal with cryptocurrency options, DeFi options are the best choice 🙂
Let’s take a look at the 5 basic DeFi options strategies that can be used today.
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Strategy 1: Protective Put Options
Protective put options (also known as “married put options”) can serve as insurance for your DeFi investment portfolio. Consider this scenario: you hold ETH, which is currently priced at $2000, but you are concerned that the price may fall next month. To protect your investment, you can purchase a put option. A put option gives you the right to sell your ETH at a pre-determined price (“strike price”) on a future date.
Assuming the strike price is $1900, you pay a premium of $100 for this option. If the price of ETH falls to $1500 within the option’s time period, you have the right to sell your ETH at $1900 instead of the current market price, thus limiting your losses. In fact, your net selling price will be $1800 (strike price of $1900 minus a premium of $100), which is significantly higher than the current market price of $1500.
While this strategy involves a cost (premium), it can protect you from significant downside risks. Given the volatility of the cryptocurrency market, this protection can be a valuable tool for risk management in a DeFi investment portfolio.
Strategy #2: Covered Call Options
If you believe that the price of the ETH you hold will only rise slightly or remain flat, covered call options are a viable way to generate additional income. By selling a call option, you agree to sell the asset at a specific price, and in return, you receive a premium.
Assume you sell a call option for ETH with a strike price of $2100 and receive a premium of $100. If the price of ETH remains below $2100 throughout the duration of the option contract, the option will not be exercised, and you can keep the premium, providing you with additional income. This strategy allows you to profit from a stagnant or mildly bullish market.
If the price rises to above $2100, you would have to sell your ETH at a price of $2100. However, because you received a premium of $100, your effective selling price becomes $2200. In other words, by using a covered call option strategy, you can increase potential profits in a rising market.
Strategy #3: Bullish Butterfly Spread
The butterfly spread strategy is designed for situations where you expect significant market price fluctuations but are uncertain about the direction. In a bullish butterfly spread, you simultaneously purchase call options and put options with the same strike price and expiration date.
Assuming the current price of ETH is $2000. You expect significant volatility but are unsure whether it will rise or fall. Therefore, you purchase put options and call options with a strike price of $2000 and pay a premium of $150 for each option.
If the price of ETH jumps to $2500, your call options allow you to buy ETH at a price of $2000, resulting in a profit of $200 ($500 price difference minus $300 premium). If the price drops to $1500, your put options allow you to sell ETH at a price of $2000, resulting in a profit of $200 ($500 price difference minus $300 premium). Regardless of the price movement, the butterfly spread strategy allows you to profit from a volatile market.
Strategy #4: Protective Collar
The protective collar strategy is a defensive strategy used when you want to limit potential losses on an investment without overly restricting potential gains. It involves holding an asset, selling call options above the current price, and buying put options below the current price.
Assuming you hold ETH with a current value of $2000. You can sell a call option with a strike price of $2200 and buy a put option with a strike price of $1800. This way, your potential losses (and gains) will be limited.
If the price of ETH falls below $1800, you can exercise the put option and sell at a price of $1800, limiting your downside. If the price rises above $2200, the holder of the call option will exercise it, and you would have to sell your ETH at a price of $2200, limiting your upside. The collar strategy provides a safety net in a volatile market.
Strategy #5: Long Straddle Options
A long straddle option is another strategy used when you expect significant market price fluctuations but are uncertain about the direction. Similar to a long strangle option, it involves buying both call and put options with different strike prices. Long straddle options offer greater flexibility and are also cheaper.
Assume the trading price of ETH is $2,000. You buy a put option with a strike price of $1,800 and a call option with a strike price of $2,200, each option costing $100. If the price of ETH drops to $1,500, you can exercise the put option and sell your ETH at the price of $1,800, resulting in a profit of $100 (the difference of $300 minus the $200 premium). Conversely, if the price jumps to $2,500, you can exercise the call option and purchase ETH at the price of $2,200, resulting in a profit of $100 (the difference of $300 minus the $200 premium). Long straddle options allow you to take advantage of high volatility while limiting your maximum loss to the total premium paid.
Best Practices for Implementing Option Strategies
It is important to remember that option strategies are not foolproof and can result in losses. Conduct research and understand the mechanics and risks of each strategy. Practice good risk management and do not invest more than you are willing to lose.
DeFi adopts traditional option concepts and transforms them into innovative tools that any investor can use. Whether you want to protect your investments, generate income, or profit from market volatility, DeFi option strategies offer exciting opportunities. However, please remember that significant potential returns also come with potential risks.