Options Contract

The two fundamental types of options define the direction of the trade.

• Call Option: Grants the right to buy the underlying asset at the strike price. Used to speculate on price increases or hedge against upside risk.
• Put Option: Grants the right to sell the underlying asset at the strike price. Used to speculate on price declines or hedge a portfolio against downside risk. Example: A Bitcoin call option with a $60,000 strike profits if BTC rises above that price.

The predetermined price at which the underlying asset can be bought (for a call) or sold (for a put). This is the contract's exercise price.

• An option is in-the-money (ITM) if exercising it is profitable (e.g., a call with a strike below the market price).
• It is out-of-the-money (OTM) if exercising is not profitable.
• It is at-the-money (ATM) when the strike equals the market price. The relationship between strike price and market price defines an option's intrinsic value.

The specific date and time after which the option contract becomes void and worthless. This is a critical determinant of the option's time value.

• European-style options can only be exercised on the expiration date.
• American-style options can be exercised at any time up to expiration. Time decay (theta) erodes an option's premium as expiration approaches, all else being equal.

The price the buyer pays to the seller (writer) to acquire the rights of the option contract. This is the option's market price. The premium is composed of two parts:

• Intrinsic Value: The immediate profit if exercised (for ITM options).
• Time Value (Extrinsic Value): The additional premium reflecting the probability of future price movement before expiration. Influenced by time to expiry, implied volatility, and interest rates.

Defines the role and risk profile of each party in the contract.

• Long (Buyer/Holder): Pays the premium upfront. Has the right to exercise. Maximum loss is limited to the premium paid; profit potential is theoretically unlimited for calls.
• Short (Writer/Seller): Receives the premium upfront. Has the obligation to fulfill the contract if assigned. Maximum profit is limited to the premium received; loss potential is theoretically unlimited for naked calls. This asymmetry defines the core risk/reward structure.

The mechanisms for settling the contract's terms.

• Exercise: The act of the long position invoking their right to buy (call) or sell (put) the underlying asset at the strike price.
• Assignment: The process where the short position is notified they must fulfill the obligation (sell for a call, buy for a put) opposite the long's exercise. In centralized finance, this is often cash-settled. In DeFi, it may involve physical delivery of the underlying asset.

This is the fundamental directional classification.

• Call Option: Gives the buyer the right, but not the obligation, to purchase the underlying asset at a predetermined price (strike) by expiry. Used for bullish strategies.
• Put Option: Gives the buyer the right, but not the obligation, to sell the underlying asset at the strike price. Used for bearish strategies or hedging.

Defined by when the option can be exercised.

• European Style: Can only be exercised at expiry. This is the standard for most DeFi and crypto options due to deterministic settlement.
• American Style: Can be exercised at any time up to expiry. More common in traditional finance (e.g., equity options), offering greater flexibility but more complex pricing.

Defines how the contract's obligation is fulfilled at expiry.

• Cash-Settled: The seller pays the buyer the cash equivalent of the profit (e.g., the difference between spot and strike price). No asset transfer occurs. Common in DeFi (e.g., on-chain options protocols).
• Physically-Settled: The underlying asset itself is transferred upon exercise. The buyer of a call receives the asset; the seller of a put must accept it. Common for NFTs and specific commodities.

A classification based on complexity and customization.

• Vanilla Options: Standardized contracts with simple, well-defined terms (strike, expiry, underlying). Calls and puts are vanilla options.
• Exotic Options: Feature non-standard payoff structures or conditions. Examples include barrier options (activate/expire if price hits a level), Asian options (payoff based on average price), and binary options (all-or-nothing payout).

Describes the seller's (writer's) position and associated risk.

• Covered Call: The seller owns the underlying asset they have promised to sell via the call option. Limits downside risk.
• Naked (Uncovered) Option: The seller does not own the underlying asset backing the contract. Carries theoretically unlimited risk (for calls) or significant risk (for puts) if the market moves against them.

A protective put is the classic hedging strategy. An investor holding an asset (e.g., ETH) can buy a put option to lock in a minimum sale price, insuring against downside risk. This defines a floor price for the portfolio. Similarly, a covered call can hedge against stagnation by generating premium income from selling call options against a held asset.

Options allow traders to speculate on price direction with limited risk and high leverage. Buying a call option provides exposure to an asset's upside for only the cost of the premium, with maximum loss capped at that premium. This creates asymmetric payoff profiles. Advanced strategies like straddles (buying a call and put at the same strike) profit from volatility regardless of direction.

Option sellers earn premiums by taking on the obligation to buy or sell. Common strategies include:

• Covered Call Writing: Selling calls against owned assets to generate income.
• Cash-Secured Puts: Selling puts with cash reserved to potentially buy the asset, earning premium while waiting for an entry price. In DeFi, protocols like Lyra and Dopex automate this, allowing liquidity providers to earn yield by underwriting options.

Options enable structured income strategies beyond simple buy-and-hold. The wheel strategy combines selling cash-secured puts and covered calls in a cycle to systematically acquire assets and generate premium flow. Credit spreads (e.g., iron condors) involve selling one option and buying a further out-of-the-money option to define risk, collecting a net premium for a high probability of profit within a range.

Options provide strategic pathways for asset transactions. An investor can use a cash-secured put to define a desired purchase price; if the price falls to the strike, they are assigned the asset, otherwise they keep the premium. Conversely, a covered call can be used to define a sell target; if the price rises to the strike, the asset is called away at a profit plus the premium earned.

Traders can use options to take a view directly on implied volatility (IV), not just price direction. Buying options (long straddle/strangle) profits when realized volatility exceeds the IV priced into the premium. Selling options (short iron condor) profits when the asset price stays range-bound and volatility is low. This makes options essential for trading volatility as a distinct asset class.

Traditional options rely on a trusted central counterparty (CCP) to guarantee settlement. In DeFi, this risk is mitigated through non-custodial smart contracts and collateralization. Key models include:

• Fully-Collateralized Writers: Option sellers must lock the full notional value, eliminating default risk.
• Automated Exercise & Settlement: Expiry and payout are executed trustlessly by the protocol's code, removing manual intervention and failure points.

The fair pricing, exercise, and settlement of options are critically dependent on price oracles. This introduces the oracle risk:

• Expiry Price Feeds: The settlement price at expiry must be accurate and manipulation-resistant.
• Pricing Models (Greeks): Protocols like Black-Scholes require a reliable spot price and volatility feed.
• Front-running Attacks: Adversaries may attempt to manipulate the oracle price near expiry to trigger or invalidate profitable options.

Unlike centralized exchanges, DeFi options often rely on liquidity pools (e.g., AMMs for options tokens) or order books. This creates specific risks:

• Low Liquidity: Can lead to high slippage when entering or exiting positions, eroding profitability.
• Impermanent Loss for LPs: Liquidity providers in options AMMs face complex loss scenarios based on volatility and price movement.
• Concentrated Liquidity: While it improves capital efficiency, it can increase vulnerability to large, directional market moves.

The entire system is governed by immutable or upgradeable smart contracts, which are primary attack vectors.

• Logic Bugs: Flaws in the options pricing, exercise, or fee calculation logic.
• Governance Attacks: For protocols with admin keys or decentralized governance, malicious proposals could alter parameters destructively.
• Integration Risk: Vulnerabilities in dependent contracts, such as oracle adapters or collateral vaults, can cascade into the options layer.

For under-collateralized or leveraged options positions (e.g., in vault strategies), liquidation risk is paramount.

• Volatility Spikes: Rapid price moves can trigger liquidations of collateral backing short options.
• Liquidation Engine Efficiency: Inefficient or delayed liquidations can result in bad debt for the protocol.
• Collateral Type Risk: Using volatile assets (e.g., other crypto tokens) as collateral increases the likelihood of liquidation events.

Different protocols architect solutions to these risks:

• Hegic: Uses a pooled, fully-collateralized model for vanilla options, with liquidity concentrated in vaults.
• Lyra: Employs a Delta-Hedged Liquidity Pool where LPs are dynamically hedged to mitigate impermanent loss.
• Dopex: Features Option Vaults for passive selling and uses Atlantic Straddles for unique collateral management.
• Premia: A hybrid AMM combining peer-to-pool and peer-to-peer dynamics for liquidity.

A call option grants the holder the right, but not the obligation, to buy the underlying asset at a predetermined strike price on or before the expiration date. It is a bullish instrument, used to speculate on price increases or hedge against them.

• Payoff: Profit if the asset price exceeds the strike price plus the premium paid.
• Example: Buying an ETH call option with a $3,000 strike to gain upside exposure without owning ETH directly.

A put option grants the holder the right, but not the obligation, to sell the underlying asset at a predetermined strike price on or before expiration. It is a bearish or protective instrument.

• Payoff: Profit if the asset price falls below the strike price minus the premium paid.
• Use Case: Used for hedging a portfolio against downside risk or speculating on a price decline.

The strike price (or exercise price) is the fixed price at which the option holder can buy (call) or sell (put) the underlying asset. It is the central variable determining an option's intrinsic value.

• In-the-Money (ITM): For a call, when market price > strike. For a put, when market price < strike.
• At-the-Money (ATM): Market price ≈ strike price.
• Out-of-the-Money (OTM): For a call, when market price < strike. For a put, when market price > strike.

The option premium is the price paid by the buyer to the seller (writer) to acquire the rights of the option contract. It is composed of two main elements:

• Intrinsic Value: The immediate profit if exercised (for ITM options).
• Time Value (Theta): The additional value based on the probability of the option becoming more profitable before expiration. Time value decays as expiry approaches.

Perpetual futures are a related derivative that allows for leveraged long or short positions on an asset's price without an expiry date. Unlike options, they represent an obligation, not a right.

• Key Mechanism: Uses a funding rate paid between longs and shorts to tether the perpetual contract price to the underlying spot price.
• Contrast with Options: Provides linear payoff and requires constant margin maintenance, unlike the defined-risk, non-linear payoff of options.

A decentralized options protocol is a smart contract-based platform that facilitates the creation, trading, and settlement of options contracts on-chain. It automates the roles of traditional options exchanges and clearinghouses.

• Core Functions: Manages collateralization, price feeds (oracles), exercise, and settlement.
• Examples: Protocols like Lyra and Dopex use automated market makers (AMMs) or peer-to-pool models to provide liquidity and price options.