AiFi Research: Why are options important in Defi ?
The latest proliferation of products，protocols and the algorithms greatly increases the complexity of the booming DeFi world. The high volatility of the underlying cryptocurrency, the complex Defi products, combined with FOMO atmosphere of the market, poses significant risks for all participants. Options, widely used in traditional financial, have a great potential to apply in Defi trading and protect user assets. This article explains why options are important in Defi.
What is Option Contract？
Option contracts give you the right to buy or sell a particular asset at a later date at an agreed-upon price (known as the strike price). In essence, options contracts are a leveraged bet on whether or not the price of an asset will go up or down within a certain period of time. Like any trade, there’s always someone on the other side. The “seller” writes the contract, listing the strike price as well as the premium. If the contract is not exercised and it expires, sellers earn the premium for selling the contract while committing to honor the strike price if redeemed. The option contract transactions on are completely trustless through smart contracts, requiring no 3rd party assessors to validate claims.
How Option Act as An Insurance Measure ？
Protection, insurance, and hedging is a vital piece to any mature financial system. In the conventional finance world, options have always had such function, and it is no different for Defi. The fundamental idea is very simple, while you may have every reason to believe the token price will go up, buying into a put options work as insurance by giving the buyer the right to sell a set token at a specified price within a predefined period. This means that no matter how low the token price goes, the buyer of the option contract can always sell the token at the agreed-upon price. The price of the token may never drop that low for the duration of the contract, and may actually increase as you predicted. In that case, the contract is not exercised, and you lose the premium, just like the premium you would pay for an insurance policy.
Why Defi market needs option?
Although Defi is growing rapidly, it is still an industry in its infancy. While various new products bring in new opportunities, it’s still in a “wild west” phase and constantly evolving. From an asset value point of view, this leads to the high volatility of underlying crypto assets. In the meantime, due to low barrier-to-entry to list tokens on DEX, users are directly exposed to many projects that may be shady in their value support. There are also associated risks in the current Defi products, such as the proper evaluation of collateral ratio in Lending/Borrowing, and the risks associated in yield farming when building a complex strategy. These factors all lead to risks in Defi asset management that are currently often neglected or underestimated.
Users want to get the most out of the new Defi trade, but they are also worried about the risks of liquidity, depreciation, relative volatility, and so on. Therefore it’s important to select the corresponding option as insurance when facilitating Defi trades.