Options belong to the group of derivative products; i.e. the products whose value is derived from the underlying value of the derivative, such as a share. Specifically, options give the buyer of the option the right, but not the obligation, to buy (call) or sell (put) the underlying asset by a specific date (American option) or at a specific date (European option) at a predetermined price (the strike price). The option buyer pays the option seller a fixed price for this right, the so-called option premium.
Options are central “Lego building blocks” for every financial system, with which financial players can not only build up leveraged positions (e.g. increase profit leverage by buying a call option) but also hedge against the risk of price losses (e.g. by buying a put option to limit maximum loss). The second seems to me to be a very essential factor for the DeFi world: As we all know, most coins are characterized by considerable volatility (e.g. Bitcoin has lost 35% of its value against the USD in the last five months). It could therefore be worthwhile for the risk-averse investor (if one can even speak of risk-averse investors in the DeFi space…) to hedge against price losses by buying put options for the collected coins.
One of the most famous examples of a decentralized protocol for options is Hegic. Hegic went live in February 2020 and is therefore still quite young, like pretty much every DeFi protocol. Hegic is a peer-to-pool options trading protocol that runs on Ethereum and supports two use cases, which we now want to take a closer look at.
User case 1: Buy options
In the first use case, Hegic offers its users the opportunity to buy both Ether (the native currency of Ethereum) and wrapped Bitcoin (Bitcoin which has been “converted” for use in Ethereum) call and put options for a fixed premium. This allows the buyer to build leverage or hedge against volatility. Let’s take a step-by-step look at the corresponding user journey:
Step 1: open www.hegic.co in your browser and click “Use Hegic Now” to start the user journey.
Step 2: You will now be asked to connect to your wallet. In my case, that means I connect the Hegic application to my MetaMask wallet.
Step 3: After connecting, I now see the cockpit, which I can use to configure my at-the-money option according to my personal taste: I can switch between call and put, choose ETH or WBTC as the currency, specify the option duration in number of days and of course specify the desired volume (number of ETH or WBTC). The option premium to be paid changes according to the entries. In this example I choose a call option for 1 ETH and 15 days. As you can see in the screenshot below, this call option costs me 198 USDC (USDC = US Dollar stablecoin) and it seems like my wallet does not have enough USDC to make the purchase (see the “Not Enough USDC” message). This means that next I would have to get the missing USCD via Uniswap or another DEX before I can buy the option. But that’s too cumbersome for the demo, so I end the user journey at this point.
User Case 2: Issue/ sell options
In the second use case, Hegic offers its users the opportunity to earn a fixed premium by selling call or put options: Users can deposit Ether or Wrapped Bitcoin in a liquidity pool to sell call options or they can deposit USDC to sell put options. In both cases, you not only earn a fixed premium, but as a liquidity provider you also receive HEGIC tokens as an additional incentive (keyword: liquidity mining). HEGIC tokens are Hegic’s native tokens which grant their holders the right to receive a share of the protocol fees and participate in protocol governance (the HEGIC token holders can submit proposals for the further development of the protocol and vote about proposals). Again, let’s take a step-by-step look at the corresponding user journey:
Step 1: Open www.hegic.co in your browser and click “Use Hegic now” to start the user journey. Connect Hegic to your wallet as described in the use case above.
Step 2: Now we don’t want to buy options, we want to deposit our coins in Hegic’s liquidity pool to earn option premiums. To do this, we navigate to “Deposit” and then see the form for specifying the liquidity tranche that we want to deposit. In our example, I decide to just deposit a tiny amount of 0.001 ETH into the At-The-Money Call Pool for the demo. Apparently there are already 992,024 ETH in the pool, which means that my share of the entire pool is almost 0%. Please remember that earlier in the article we said that the Hegic protocol is a peer-to-pool protocol; that means my deposited ETH is not pledged 1:1 as collateral for a specific separate option, rather my ETH is added to the relevant liquidity pool for ETH ATM calls and the individual purchased options run against the entire pool. Of course, this means that the pool (and my small share of the pool) earns more if more users buy the corresponding options via use case 1 above and pay the option premium to the pool. Accordingly, at the time I deposit my ETH, I do not yet know exactly how many rewards I will actually receive in the end. However, the platform tells me that I can expect around 18.67% APY (APY = Annual Percentage Yield including the compound interest effect). And by the way: As we can see from the GUI, my deposited ETH will be locked in the pool for a period of 30 days. Then I get them back100%… in case the option buyers don’t exercise their call options!
Step 3: To finalize the use case, I click “Deposit and Start Earning Now” and confirm the transaction in my MetaMask wallet. Et voilà… now I’m the proud owner of a small stake in the Hegic ETH ATM Call Liquidity Pool.