What are Call Options, Put Options, and what are DeFi Options used for?

Learn about the very basics of DeFi options!

Understanding Options

💡 In this article, you will learn about:

1. Call Options: Call options grant their holder the right to buy an asset at a specified price and date.

2. Put Options: Put options grant their holder the right to sell an asset at a specified price and date.

Call Options

Buying a call option is similar to paying upfront for a table at a restaurant, since even though you've secured the table, you only lose what you paid for the reservation if you decide not to go.

Put Options

Buying a put option is similar to paying upfront for insurance, since you're protected if something happens to your house.

What Are Options Useful For?

1. Leverage: Options allow traders to control a larger amount of an asset with a relatively small initial investment, potentially amplifying gains but also increasing potential loss.

2. Risk Management: Options can be used to provide some protection to your existing holdings and positions without having to sell your assets. 

3. Income Generation: Investors can use different options strategies to generate additional income from their existing holdings. In DeFi, users can deposit into strategy vaults or liquidity pools to earn income from options without directly trading them.

4. Speculation: Traders can use options to speculate on the future price movements of the underlying asset, potentially profiting from both upward and downward market movements.

Key Takeaways

1.1 What Are Options?

What are financial Derivatives, how do Derivatives work in practice, and what is the difference between DeFi Options and Perpetual Futures?

Learn about derivatives and what makes options unique

Understanding Derivatives

The differences between options and futures

What Are Derivatives?

What Are Derivatives Useful For?

1. Leverage: Financial derivatives often allow traders to use leverage.  Leverage means being able to control a larger amount of an asset with a relatively small initial investment. Using leverage amplifies potential gains, while also increasing potential losses. 

2. Speculation: Traders can also use derivatives to make guesses about what might happen in the future. 

If a trader believes ETH will go up in price, they could use a financial derivative that gives them the potential to profit from ETH going up in price, such as a call option or a perpetual futures contract.

3. Hedging: Derivatives can be used to hedge existing positions.

Hedging means reducing the potential risks of an asset or investment without having to sell the asset. It can help traders protect their investments against negative price movements.

4. More Flexibility: Derivatives offer more flexibility compared to traditional investments.

They can be customized to fit various strategies, timeframes, and risk appetites, making different derivatives useful as powerful and flexible tools for investing.

Financial Derivatives in Practice

1. Futures: Bob believes that the price of ETH will fall in the near-term. Bob can then enter a "short" position that locks him into selling ETH at the current price in the future, providing him with the possibility of profiting from the price of ETH falling. If things turn out as Bob expected, and ETH falls in price, Bob will make a profit. If ETH ends up stagnating or rising in price, however, Bob will end up at a loss since he will have to sell ETH below market price.

2. Options: Bob just entered a short position on ETH, locking him into selling ETH at the current price in the future. Bob wants to protect himself against potential losses from ETH rising in price, so he buys ETH call options, that give him the right, but not the obligation, to buy ETH at a certain price and date in the future. If ETH falls in price, Bob makes a profit from his short position, and only loses the premium he paid for the call option. If ETH rises in price, Bob profits from his call options, effectively reducing the losses he takes from his short position.

Differences Between Futures and Options

1. Nature of the Contract: Futures are agreements to buy or sell an asset at a fixed price and time in the future, while options give their buyer the choice to buy or sell an asset at a fixed price and time in the future.

2. Profit Potential: Futures offer theoretically unlimited profit potential but also unlimited loss potential, while options have limited profit potential but also limited loss potential.

3. Risk and Reward: Futures are riskier than options because they are binding. The buyer is obligated to fulfill the contract even if they lose money. On the other hand, options provide the buyer with a choice, offering more flexibility and limited loss potential.

4. Pricing: Futures generally have a fixed price determined by the market, while the price for options has to be determined with complex pricing models, such as the popular Black-Scholes.

5. Flexibility: Options offer more flexibility than futures contracts, because the buyer has the choice to use the option, while futures must be fulfilled. Additionally, options can be customized to meet specific objectives and risk profiles, while futures are standardized and less customizable.

1.2 Understanding Derivatives

What are the Strike Price, Expiration Date, and Option Premium of a DeFi Option?

Learn about the Strike Price, Expiration Date, and Option Premium!

Understanding Options: Key Definitions and Components

Understanding the Definitions and Components of Options

Call options give their buyer the right to buy the underlying asset at the specified strike price and expiration date. Call options are typically bought when the investor expects the price of the underlying asset to increase. Investors might also sell call options for profit while expecting prices to fall.

Put options give their buyer the right to sell the underlying asset at the specified strike price and expiration date. Put options are typically bought when the investor expects the price of the underlying asset to decrease. Investors might also sell put options for profit while expecting prices to rise.

Strike Price

Call options give their holder the right to buy an asset at the strike price.

Put options give their holder the right to sell an asset at the strike price.

Expiration Date

A call option with an expiration date that is one year from now is generally more expensive than a call option with an expiration date that is only one month from now.

Option Premium

The premium for an option becomes more expensive as the likelihood of reaching the strike price increases. 

Option Size

A call option on ETH with a contract size of 10 ETH gives you the right to buy 10 ETH at the strike price.

Takeaways

1.3 Understanding Options: Key Definitions and Components

What are European Options, American Options, and what's the difference between them?

Learn about the key differences and implications of European Options and American Options!

European Options vs American Options

The differences between European and American options

European and American Options

European options are basic options that can only be exercised at the expiration date. 

American options are basic options that can be exercised at any time before the expiration date. 

Differences Between European and American Options

1. Exercise Rules: European options can only be exercised on the expiration date, while American options can be exercised at any time before or at the expiration date. This difference affects the strategies that investors and traders can use when utilizing these options.

2. Option Premium: American options generally have a higher premium than equivalent European options, as the ability to exercise the option at any time before expiration offers additional flexibility to the buyer. Additionally, American options in DeFi are often even heavier in fees due to their complexity.

3. Risk of Early Exercise: American options expose the option seller to the risk of early exercise, which can impact their profits and strategies. European options do not carry this risk, as they can only be exercised at expiration.

Implications for Traders and Investors

1. Hedging: European options may be more suitable for investors who need to hedge for a specific event or date, such as an announcement or a known economic event. American options can be more appropriate for investors who want the flexibility to manage their hedges dynamically, adjusting their positions as market conditions change.

2. Income Generation: Traders looking to generate income from options writing may prefer American options due to their higher premiums. However, they must also be prepared to manage the risk of early exercise.

3. Speculation: Investors who want to speculate on the price movements of an underlying asset should consider the different exercise rules and premiums when choosing between European and American options, as these factors can impact the risk-reward profile of the trade.

1.4 European Options vs American Options

Test your knowledge gained from the Introduction to DeFi Options course!

Exam: Introduction to DeFi Options

1.5 Exam: Introduction to DeFi Options

Kick off your academic journey with an introduction to the world of financial derivatives and DeFi options!

Dive into DeFi options basics and the difference between traditional options and Premia’s DeFi options!

Course overview

1. Introduction to DeFi Options

1.1 What Are Options?

1.2 Understanding Derivatives

1.3 Understanding Options: Key Definitions and Components

1.4 European Options vs American Options

1.5 Exam: Introduction to DeFi Options