DeFi Options: The Ultimate Beginners Guide

What Are Options?

An option is a financial contract that gives the owner the right but not the obligation to buy (a call option) or sell (a put option) an underlying asset at a specific price on or before an expiration date. 

Options are known as derivatives because they derive their value from a different underlying asset. This asset could be a stock, a cryptocurrency, or a commodity.

Options contracts all contain:

• An underlying asset

• An expiration date

• Type (call vs put)

• Premium (how much an option is sold/bought for)

• Strike price (the price at which an option is exercised/assigned)

Put options profit when the underlying falls in value while call options profit when the underlying rises in value. However, just because the underlying moves are in your favor does not necessarily mean your option will be profitable. Remember, you have to factor in the premium you paid for that option.

What Are The Advantages of Options Trading?

Options offer traders two main advantages:

• The flexibility of investment: A major advantage of options is their versatility. Unlike traditional securities, options provide the opportunity to profit in any market, including when it moves down or trades sideways (market neutral).

• Hedging: Options can serve as an insurance policy to protect traders from potential losses in downturns (or upturns for short sellers). Traders can buy or sell options to minimize the impact of adverse market movements.

• Leverage: One options contract typically represents 100 shares of stock.

What Are DeFi Options?

Traditional options trading is not very transparent and accessible only to those who have been pre-approved (which requires experience and a minimum net worth). DeFi introduces many advantages over traditional options trading:

• Trustless: DeFi options do not rely on intermediaries – smart contracts handle the transactions as well as the clearing of transactions. Trading is non-custodial (self-custodial), meaning that no party takes custody of assets.

• Open: DeFi options trading is available 24/7 with prices being updated algorithmically. Trading is often possible without a KYC (know-your-customer) process, making it accessible to anyone globally with a crypto wallet, regardless of their status as an approved options trader or institutional investor.

• Flexibility: DeFi option contracts are exercisable at any time, kind of like American options in TradFi. Exercise is guaranteed by liquidity locked within smart contracts. 
  
  

The Risks Of DeFi Options Trading 

There are also some risks associated with DeFi options trading.

• High volatility: A key element of options trading is that users speculate on the future price of an asset in order to turn a profit. However, the volatility of crypto markets can pose a challenge, especially for inexperienced traders. A single large movement of the underlying can prove disastrous to a portfolio.

• Risky leverage: Some DeFi platforms allow traders to use very high leverage. This increases the potential for gains, but also for losses.

• Sometimes holding is better than trading: In bullish crypto markets, simply holding a cryptocurrency is often more profitable than options trading due to time decay (theta).

• Errors in programming: Faulty DeFi protocol smart contracts can have financial consequences for those involved.

• No FDIC Insurance: Unlike traditional brokers, there is no FDIC insurance in DeFi. 

How Do DeFi Options Work?