#Midnight protocol vault full#

If we perfectly hedge a bought or sold option, we should expect to make zero profit, by the fundamental asset pricing theorem (akin to no-arbitrage). This is an extremely dirty metric, since it not only accounts for true forecasted volatility over the lifetime of the contract, but also the added cost of basis risk.īut in practice, it tends to give us a good coordinate system for decomposing the very non-linear options payout (convexity) into a system of linear exposures (the Greeks). Generally, this can be derived through back-solving the formula - starting with a decent seed guess (like historical volatility), we observe real-world prices and can compute a market price for implied volatility. Similarly, the Black-Scholes formula relies heavily on the notion of pricing implied volatility. We usually hand-wave these under the term basis risk, and have DLC packs added to the Black-Scholes model in order to try to match real-world pricing better.

It makes some clearly impractical assumptions, including of course:įrictionless markets (so no transaction costs) It is the expected cost, from the time an option is written to its expiry, of continuously re-hedging a portfolio consisting of the underlying in relation to its probability of ending up in-the-money (roughly its delta). More on point - the cost of a vanilla option under Black-Scholes has a clear, non-mathematical interpretation. This creates gap risk and noticeable seasonality effects in equity volatility trading. For example, during weekends and after-hours, vanilla equity options are largely untethered from implied price movements, given an option seller cannot easily rehedge their position while prices may change substantially. In practice, very few contracts have a true perfect static (meaning, after t=0, no further buying or selling is needed to hedge during the contract’s lifetime) or even dynamic (further buying/selling/rebalancing) hedge. Identical is doing heavy lifting in that sentence.

#Midnight protocol vault full#

The pricing of derivatives is an interesting arcana mostly for retail traders, while more sensible people stick to delta-one trading so they don’t have to hedge their vomma exposure every full moon.īlack-Scholes, like most derivative pricing, is built on the idea of portfolio replication - given no actor preference, the price of a derivative should be equivalent to the cost of replicating a portfolio (uncreatively called the replicating portfolio ) that, over the lifetime of the derivative contract, provides identical cash flows. This isn’t metaphorical - the structure of the market and preferred approach on a protocol basis is fundamentally unsustainable, and no amount of liquidity emissions can change that.ĭespite what many want to believe, Black-Scholes isn’t just some letters on a chalkboard. A derivative can become fully untethered from the idea of a reference underlying - much like the expansion of the CDS markets, in the absence of regulations and requirement for custody, there’s little except imagination preventing the options notional market size of a cryptocurrency or primitive from eclipsing the size of its underlying.īut the market, as is, grows under the sword of Damocles. We can do away with limiting nonsense like the need to own the underlying entirely as well.

So you can piss in the face of stuff like liquidity or worrying about options hedging notably impacting market movements. Perhaps more saliently, the DeFi options market tends to be richer in breadth than even CeFi alternatives like Deribit or CME, given that well, anyone can make a DeFi options protocol.

At its core, true decentralized options take advantage of smart contracts and settlement layers to avoid the need for centralized clearinghouses and exchanges which, turns out, can just reverse your nickel trades if they feel like it.

There are many interesting reasons to be optimistic on DeFi options. In the case of Hegic, Premia, Dopex, and others, this occurs on a bespoke basis - options are written when a buyer interacts with the pool, meaning similar to traditional AMM architecture, yield is only created in a sustainable basis by actual demand for liquidity. In the case of Ribbon Finance, for instance, this writing occurs at preset intervals, with flow being auctioned (I believe in Ribbon’s case via Gnosis). While there exists some differences between vault implementations, the most common approach utilizes option-writing pools, which essentially write options by backing the contract by locking quote (in the case of put-writing) or base (for call-writing) assets for a set duration.