2.4 DeFi Options in Practice

Options are financial derivatives that can give their holder the right to buy or sell an underlying asset at a specified strike price and expiration date.

They can be a useful tool for investors looking to speculate on price movements, hedge against potential losses, generate income, or implement trading strategies.

Let's go in-depth with some of the practical applications and outcomes of using options.

Long call and long put positions can be used to speculate on the future price movements of an asset.

This can be a useful tool for investors who have conviction on a direction that the price of an asset like ETH will take in the future. For example, let's say an investor believes that the price of ETH will increase in the next three months. They can enter a long call position by buying ETH calls that expire in three months.

If the price of ETH does indeed increase, the investor can exercise the option and make a profit. However, if the price of ETH remains the same or decreases, the investor may choose to let the option expire, in which case they would only lose the cost of the premium.

Options can be used to hedge against potential losses in current positions.

For example, let's say an investor owns 10 ETH and is concerned that the price may decrease in the future. They can purchase an ETH put option with a strike price equal to the current market price of ETH. If the price of ETH does indeed decrease, the investor can exercise the option and sell ETH at the higher strike price, mitigating their losses. However, if the price of ETH increases, the investor may choose to let the option expire, in which case they would only lose the cost of the premium.

Investors can directly generate income from options by underwriting (selling) them.

This can be a useful tool for investors who own ETH, don't expect the price to increase significantly, and want to earn yield on their holdings.

For example, let's say an investor owns 10 ETH and expects the price to stagnate. They can sell an ETH call option with a strike price above the current market price of ETH. If the price of ETH does not increase above the strike price, the investor can keep the premium collected. However, if the price of ETH increases above the strike price, the investor may be obligated to sell the ETH at the lower strike price, resulting in a loss.

Options can be used in a multitude of strategies for different purposes.

For example, an investor can combine different positions to create strategies with varying levels of risks and rewards. One commonly used options strategy is the call spread, where an investor purchases an ETH call option with a lower strike price and sells an ETH call option with a higher strike price. This strategy limits potential losses while still allowing potential for profit.

Another common strategy is the covered call, where an investor owns ETH and sells an ETH call option with a strike price above the current market price of ETH. This strategy can generate income from the premiums collected but also limits potential gains if the price of ETH increases significantly.

It's important to note that call options are complex financial instruments and involve significant risks.

In conclusion, options can be a useful tool for investors looking to speculate on price movements, hedge against potential losses, generate income, or implement trading strategies.

Each practical application of options has its own potential outcomes, and it's important for investors to fully understand these outcomes before implementing any strategy. As with any investment, it's important to do your own research and understand what you're getting into.