The risks in the DeFi liquidity mining market are surging. How to hedge through options?

Reposted from: FNX Fans

Since the beginning of September, Ethereum and popular DeFi currencies have fallen sharply , pouring cold water on the market that has just fallen into a frenzy. Many investors participating in liquidity mining have suffered a series of losses in just a few days, including a sharp drop in locked currencies, a sharp decline in mining income, and even losses in liquidity market making.

This has caused many users who are currently engaging in liquidity mining and many users who are about to enter the DeFi market to feel hesitant. Public data shows that the total amount of DeFi locked-in funds has shrunk significantly in the past week.

Image source: DeFiPulse Screenshot date: September 14

In the current environment of highly uncertain market prospects, users want to participate in the rapid development of the DeFi market, but are also worried about the risk of a short-term market crash and huge losses; they want to buy locked currencies but don’t know whether the current price is too high; and they are also concerned about whether a rapid rise in the DeFi market will lead to missing out or inefficient use of funds, etc.

In fact, all these concerns can be solved through options tools. By combining options with liquidity mining, DeFi users can achieve the highest level of returns under controllable risks.

What are options?

An option, also known as a call option, is a derivative financial instrument. It is a right to buy or sell a certain amount of underlying assets at a certain agreed-upon price at a certain agreed-upon time in the future . Option is one of the most important derivative instruments in the traditional financial market for leveraged trading, improving capital utilization efficiency and risk management.

To give a simple example, if users are already conducting liquidity mining in DeFi applications, but are worried that the staked and locked currencies such as ETH , LEND or SNX will plummet.

Then, users can buy put options (PUT) of these currencies, which is equivalent to buying insurance for their positions. They can still obtain liquidity mining income when the market plummets, but it will not cause the pledged and locked currencies to encounter market risks. At the same time, they can also obtain unlimited upward returns when the market rises. It is more advantageous than hedging with futures, as shown in the following figure:

Advantages of Options

DeFi users are very familiar with hedging operations using equal-value spot and equal-value futures contracts in the opposite direction . This hedging operation can offset the opposite changes of spot and futures at the same time to protect the changes in two-way price changes. However, this hedging method has a certain risk of high-leverage liquidation , and will also cause users to lose some of the benefits of one-way trend changes.

Such risks can be avoided through options . If a user currently holds 100 ETH at a unit price of $380, the user can pay a certain option premium X to buy a (par) put option with an exercise price of $380.

1. If the ETH price falls below $380, the profit from the option and the loss from the spot price will offset each other, and the most that will be lost is the "premium" of buying the option.

2. If the ETH price rises, the remaining part of the spot price increase after deducting the premium X can be used as profit.

If users are familiar with such option hedging operations, they can also try more advanced methods to suit their own risk preferences and price judgments.

Still taking the above picture as an example, if the user thinks that the option with an exercise price of $380 is too expensive and wants to buy cheaper "insurance" to hedge, and at the same time judges that the price of ETH will not fall sharply, but the probability of rising will be greater.

Then the user can buy an (out-of-the-money) put option with an exercise price of 340 yuan or even lower. This option will provide insurance against a sharp drop in price to below 340 yuan, and at the same time only requires a lower premium than X, which is more suitable for the user's personalized hedging needs.

Taking FNX liquidity mining as an example, the current APY is about 540%, the daily income is about 1.5%, and the ETH market price is 380. The user intends to use 100 ETH for liquidity mining to obtain FNX income. Referring to the current ETH option contract data, the user can buy 100 5-day put options with an exercise price of $340, which costs about 0.7ETH (0.007ETH*100). After 5 days, the income from mining FNX is as follows:

As can be seen from the above figure, once the ETH price drops to 320, the user's ETH base position will lose 16%, but if it has option protection, the final loss will only be 4% after taking into account the mining income . This income structure only requires an initial investment of 0.7ETH (equivalent to US$266) to provide a loss protection effect of nearly 6% for the user's large position.

In addition, if the user believes that the market is in a state of volatility and will not rise or fall sharply, then more options combinations can be used to obtain income or reduce their premiums. For example, sell an (out-of-the-money) call option with an exercise price of $400 and use the proceeds from the sale of the call option to offset the premium of the purchased put option. The income returns of the spot and option combination are shown in the figure below:

From the above figure, we can see that when the user expects ETH to be in the fluctuation range of 340-400 US dollars, the user can obtain the benefits of ETH appreciation. Once the price drops by more than 340 yuan, the user can still obtain the protection of the put option , and the premium income from selling the call option can offset the premium fee of buying the put option. This combination is more suitable for users who have a certain ability to predict the ETH market.

As the depth and breadth of the DeFi market increase, user trading, hedging, leverage and other needs will become more diversified and complex, and financial derivatives such as options will usher in explosive development. Understanding option trading or starting to learn about option trading is the general trend of the DeFi market. Decentralized financial derivatives protocols and platforms themselves have become the golden track for the future development of DeFi.

Above, we introduced the basic principles of options and the basic strategies for risk hedging in liquidity mining, including achieving downside insurance by buying put options, and adjusting premium fees by buying options with different strike prices.

However, the actual users of DeFi and liquidity mining markets are more diverse, and the demands for risk and return structure in actual investment behaviors are more complex. This article will introduce some higher-level strategies and gameplay of options in DeFi and liquidity mining markets.

The most basic need of DeFi users is to worry about the risk of a sharp drop in the staked currencies, such as ETH, LEND, SNX, etc. However, in actual situations, the more common demand is that if DeFi users begin to make up their minds to enter the liquidity mining market, they are very worried about the timing.

In particular, they are worried about whether buying ETH, LEND or SNX and other currencies now is a bargain hunting halfway up the mountain, while also hoping to enter DeFi liquidity mining as early as possible to avoid missing out on potential market opportunities. This is a very typical position-building mentality.

How options hedge liquidity mining risks

Liquidity mining can be combined with a very classic "Airbag" option structure. As the name suggests, this airbag structure sacrifices part of the future rising profits in exchange for a safety cushion space for building a position in the early stage.

Taking the following figure as an example, if users purchase this type of option, they will obtain a 20% downside protection space. However, if the profit after the option expires can only be withdrawn at 78%, it is equivalent to exchanging a small portion of the potential profit for a 20% downside safety protection space. Users will only lose money when currencies such as ETH fall sharply by more than 20%.

This type of airbag option is often traded on margin, and users can use very little capital to obtain a psychologically comfortable opportunity to build a position without worrying about missing out on a large opportunity or buying at the bottom halfway up the mountain.

In the worldview of options, asset prices are nothing more than a combination of risk dimensions such as direction, volatility, and time opportunities . Combining options with liquidity mining can implement strategies such as buying crash insurance and selling volatility based on liquidity mining returns combined with options.

By retaining certain risk dimensions that users want to take, such as price predictions, and splitting out risks that they do not want to take, such as volatility, we can create a digital currency "financial product" with a specific income structure that better meets the purest financial needs of DeFi users.

In fact, many of the "structured wealth management products" that users buy from banks or securities companies on a daily basis are constructed through the method of fixed income + options, which will be more flexible when mapped to the DeFi market.

The charm of options goes far beyond that. For example, options can also be combined with liquidity mining to provide structured financial products native to digital currencies .

People can often see structured products linked to gold, stock indexes, or crude oil prices at bank counters, or some annualized high-yield fixed-income products that provide index enhancement. These structured products also utilize the principles of options. The combination of liquidity mining and options can achieve the same effect.

For example, in the liquidity mining market, the Snowball option provides an automatic redemption structure, where DeFi users can sell an out-of-the-money option with specific trigger conditions.

It can be easily seen from the figure below that through this option structure, users are equivalent to selling an insurance for large investors who want to hedge spot risks and charging a fixed insurance fee. As long as the market does not experience a collapse, DeFi users can obtain very stable fixed income from volatile or even mild declines. The longer the holding period, the higher the income, just like a snowball, so it is called the Snowball option structure.

In addition to the classic snowball strategy, there are many special income structure option strategies that DeFi can learn from. The structured products mentioned above that are linked to various major asset structures are all constructed through an "American bullish shark fin" option structure, which has a high degree of matching with the current hot synthetic assets and many new ways of playing.

A more advanced way of playing is to create native structured products in the DeFi market by combining liquidity mining with options. The lack of interest-bearing assets has always been a core problem plaguing the DeFi market. In addition to mortgage lending, liquidity mining is just a new way to provide interest income for the digital currency market, but these ideas are nothing more than traditional credit income interest-bearing methods. Through liquidity mining + options, we can also create a "volatility interest-bearing" method to convert the high volatility of the digital currency market into an interest income structure.

The Snowball automatic redemption or shark fin structure mentioned above is a typical method. There is also an OBPI strategy (option-based portfolio insurance strategy), the core of which is to invest funds in income assets (liquidity mining) and invest the income (governance tokens) obtained in options, and obtain an upward and relatively safe benefit elasticity through option leverage on top of the basic income.

Among these are structures based on enhanced returns of linked assets and enhanced asymmetric structures (more benefits when prices rise, less losses when prices fall). We will reveal the mysterious core of these option structures in subsequent articles.

We can see that the most valuable significance of option derivatives lies not in leveraged trading itself, but in the ability to customize the cutting and recombination of risk characteristics of assets . Many high-net-worth clients in the traditional financial market are already accustomed to having securities companies or fund companies customize structured products with controllable risks and higher returns based on their own risk preferences and return structures. However, the asset management companies that provide these products often have very high requirements for the property threshold of users.

For the emerging future DeFi market, users can currently only accept the degree of leverage speculation of standardized options contracts through centralized exchanges such as Deribit, and are constrained by issues such as market depth, and are far from exploring the true value and charm of options.

But this also requires the emergence of competitive decentralized over-the-counter derivatives protocols and markets in the DeFi market. Only through the over-the-counter derivatives market can users customize personalized options products through a low-threshold platform and package more structured products with creative yield structures, helping DeFi and liquidity mining to release a broader market space.

Comparing with the traditional financial market, we can see that as of the end of 2019, the global OTC derivatives stock size was approximately US$560 trillion, while the global GDP was only US$85-90 trillion. The scale of OTC derivatives has become a huge behemoth.

The application prospects of over-the-counter derivatives are very broad, including the creation of structured products (structured deposits, wealth management, asset management plans, etc.), products linked to the returns of a certain underlying asset; they can also bring leverage, improve the efficiency of capital use, and achieve safety points through special income structures (such as building positions, bottom fishing, etc.).

Decentralized over-the-counter derivatives protocols and markets are naturally the jewel in the crown of the DeFi market, and are a DeFi track with potential that is a hundred times greater than leveraged lending.

We are delighted to see that projects like FinNexus have already started to run in this golden track and gained valuable first-mover advantages. Whoever can take the lead in decentralized options derivatives will become a true giant in the entire world DeFi market.