Neverending Options

When I applied for that content writer position at Bitget, I was asked to write an introduction to USDT-margined perpetual futures. It took me 1 day to crack the basics and another 24 hours to finish the article. I got an offer even though I felt something was missing from my knowledge base.

Then I started looking into perpetual futures for months on end and finally, I felt confident enough to explain what perpetual futures is to someone curious enough to ask all sorts of questions.

Later, it was both by chance and fate that I came across other crypto-related financial instruments and took another deep dive into this even more complex invention - something that has yet to exist on major exchanges - perpetual options (or everlasting options).

First, let's talk about futures

Crypto was born to disrupt the financial world and it has, albeit not how Satoshi Nakamoto intended it to. It wasn't long before someone discovered crypto's huge speculation potential and trading spot wasn't enough. Naturally, someone else turned their eyes towards derivatives.

A futures contract is an agreement between two parties to buy/sell a certain asset (the underlying) at a given time in the future, hence the name. At first, futures was invented to hedge risks associated with commodities like soy, crude oil, or gold. A seller can set a price before they can deliver the underlying and let the buyer assume some of the risks. Since you don't get the underlying when you sign the contract, you don't have to pay the full price. Instead, a deposit equal to a portion of your position's value is all you need to keep this contract valid. Therefore, you can sign a futures contract worth $100 with only $10 and if the price goes up by 10% to $110, you will get a 100% profit ($10). Such is the power of leverage.

This is ideal for crypto investors seeking to amplify their returns. And soon someone realized you don't have to deliver the product at a given time because cryptocurrencies will always be there. A futures contract that never expires looks tempting to anyone seeking 100X their investments.

There is one caveat, though. Since Satoshi Nakamoto released his famous whitepaper, the overwhelming majority of the crypto community has been longing cryptocurrencies. As a consequence, the futures market will be dominated by buyers, moving the futures price ridiculously higher than its spot price.

Traditional futures contracts also have this problem but the market has a way to figure it out. Since these contracts expire, however much the futures price deviates from their spot price, the basis will gradually disappear as we get closer and closer to the expiry date since there will be less and less of a difference between buying on the futures market and the spot market.

Same can not be said for perpetual futures. Now that they don't expire, we may never see the day when the basis disappears. Something must be done.

For the record, I don't know what happened when BitMEX invented perpetual futures but since these contracts are sometimes referred to as perpetual swaps, one can only assume that they decided to borrow a mechanism from swap contracts - an agreement between two parties to exchange cash flow, typically used to hedge the risk of oscillating loan interest rates or to exchange value between two positions.

With this mechanism, perpetual futures buyers and sellers must exchange cash flow (making 'funding payments') with each other based on the difference between the underlying's futures price and spot price. If the futures price is higher (the underlying trading at a premium), the buyers have outbought the sellers. At such times, the funding rate mechanism dictates buyers must pay sellers based on their position size. This way, sellers will have enough reason to hold on to their short positions and buyers will have their accounts bled dry if they keep their long positions open indefinitely.

Options?

The reason I spent hundreds of words talking about perpetual futures in an article dedicated to options is that I wish to demonstrate how removing a seemingly insignificant variable (expiry date) from a financial instrument may lead to starking imbalances in the market and take some of the most innovative minds to fix it by introducing a new mechanism.

Now let's talk about options.

Options are quite like futures, except futures contracts impose both parties the obligation to transact a certain asset at a given time, whereas options only give them the right. You have the option to pocket your profit when your option is in the money (ITM), as well as throw it into the bin when it's out of the money (OTM).

As such, futures contracts can be priced based on their entry price but options must charge a premium for signing this contract. This premium is the price a buyer pays a seller (writer) and options at each price tick form a market on their own. Buyers are free to choose the lowest ask they can find for a certain underlying at a certain strike price. Once again, removing one restraint (obligation to buy or sell) from a financial instrument leads to an entirely different derivative.

Traditional options already give investors immense flexibility for locking profits and hedging risks. You can hold a long position for an underlying while buying a put option of the same size for the same underlying at the same price. This way, if the price goes down, your long position is at a loss but the amount is only equal to your profit from the put option (or its seller), leaving you losing only the premium you paid for your put. If the price goes up, your long position stands to profit and you can throw your OTM put option in the bin.

As you have seen, even options that expire are already much more complex than futures. Black, Scholes, and Merton won a Nobel Prize for developing a formula for stock options valuation. But what if we take it a step further and remove the expiry date from the options, like what we did to futures?

Path dependency

As of now, two approaches grabbed my attention. One was proposed by Paradigm and the notorious Sam Bankman-Fried in their research titled 'Everlasting Options'.

In this paper, the authors proposed a universal funding mechanism for derivatives based on the difference between mark price and index price of the underlying (for futures) or the contract itself (for options). This is a generalised version of the perpetual futures funding mechanism and backed by the no-arbitrage pricing model that where there is a potential profit, there will be arbitrageurs to make the most of it. In the case of perpetual futures, buyers will pay sellers when the mark price is higher than the spot price or in the case of everlasting options, when the mark price is higher than the potential payoff.

This universal mechanism is playing the arbitrageuers and such activities are ideal for centralized exchanges since the calculations and payments can be made within milliseconds by their complex trading engine running on mega servers. Indeed, the authors mentioned the traditional crypto options market being a nightmare (in my own words) for market makers because there are just so many markets to make. Their everlasting options are equivalent to a basket of options with different expiration times and weights equal to the inverse of 2 to the power of the number of funding cycles before the expiration time. This way, market makers can concentrate their liquidity on these baskets instead of spreading it on 100 markets.

But the thing is, no one said options can only be traded on centralized exchanges with large institutions as market makers/liquidity providers. A decentralised ecosystem calls for decentralised protocols, and mechanisms that are less costly and cumbersome for smart contracts.

Enter Panoptic with their perpetual options ('Panoptions'). By comparing a put option to a Uniswap V3 liquidity pool, they proposed this on-chain option that never expires.

Uniswap V3 pools allow liquidity providers to deposit 2 assets and earn fees when the price ratio between these 2 assets is within a certain range. When it's out of the range, your liquidity becomes 100% of the asset with the lower price. Panoptic put options are essentially concentrated liquidity deployed on a single price point - its strike price. Let's pretend you hold an ETH-USDT Panoptic put option. When ETH's price goes above the strike price, this put option is OTM and becomes 100% USDT. When ETH's price is below the strike price, the buyer can give 1 ETH to the seller in exchange for all the USDT in the pool, earning the difference between the strike price and the price they paid for that 1 ETH.

Panoptic call options work exactly the same except the 2 assets must switch places.

But that's only half the formula. We still need to price the Panoptions by putting a premium on them. In contrast to traditional options, Panoptions charge no premium upfront and assume that the value of options can be realised over time.

Meet θ, a Greek letter used to define the rate of an option's value decline over time. If you studied derivatives (the mathematical one), you would know the derivative of mileage over time is velocity - the rate/speed of your mileage increase over time. And by integrating the speed over time, you get mileage. Theoretically, the same goes for options: if we integrate θ, the 'value speed', over time, we get value.

We are able to do this because there is another formula for θ instead of doing derivatives:

θ=dV(S,t)dt=Sσ 8 πt exp(−[ln(S 0 k)+σ 2 t 2]22 σ 2 t)\theta = \displaystyle \frac{dV(S, t)}{dt} = \displaystyle\frac{S\sigma}{\sqrt {8\pi t}}exp(- \displaystyle \frac{[ln(\frac{S_{0}}{k}) + \frac{\sigma^{2}t}{2}]^{2}}{2\sigma^{2}t})θ=dtdV(S,t)​=8πt ​Sσ​exp(−2σ2t[ln(kS0​​)+2σ2t​]2​)

where S denotes the underlying asset spot (or current) price, σ is the asset’s volatility, K is the strike price, and t is the time to expiration.

Note this formula is flawed since we assumed a 0 risk-free interest rate when in reality it can get quite higher. But how high? Should we take the interest rate from Binance Earn, ETH staking, Aave Lend, or heaven forbid, treasury bonds? This question may take an industry to answer.

The good news is, we still haven't said a word about oracles because by tethering Panoptions to the corresponding Uniswap V3 pool, this system won't ever need an oracle as long as there are enough traders swapping tokens via this pool.

This way, we have a simulated option on smart contracts, a premium that is price path dependent but oracle-free, and some solid knowledge in derivatives, both financial and mathematical. We are probably more ready than 99.9% of individuals on earth to trade options.

Perpetual options on-chain

Panoptic built an entire options trading ecosystem with smart contracts. Participants are divided into liquidity providers, option sellers, and option buyers.

Before anyone can do anything, liquidity providers must first deposit assets into a liquidity pool. Sellers and buyers must also deposit their collateral. Sellers need to first mint their call or put option by paying a 0.1% commission and locking up (borrowing) a certain amount of liquidity at a strike price. Then, buyers can buy these options by paying the same rate of commission, locking up some more liquidity, and minting their position.

Since our premium is accumulated over time, there should be 0 premium when the option was just sold. Instead, sellers would be credited a streaming premium every time the spot price crosses the strike price.

When exercising their options, buyers will pay back their borrowed liquidity plus premium while getting the numeraire (for put options) or the underlying asset (for call options).

On one hand, Panoptions is genius. By synthesising options with Uniswap V3 pools and settling premium when the option is exercised, the entire process is moved onto the blockchain. Anyone can access these financial instruments as long as they know their way around wallets and smart contracts. Under the ERC-1155 token standard, you can mint several options into one token for further risk and volatility customisation or even duplicate a composition someone else just shared.

On the other, since Panoptions can be minted at 0 premium and a 0.1% fee, who's to stop arbitrageurs from buying ITM options before immediately exercising them for guaranteed profit? After a few costly lessons, who's to encourage sellers into minting ITM positions only to lose money? With only OTM options, the market will be as bustling as an empty bucket.

Finding the f(law) in funding & finance

That's not to say the centralised approach has no flaw. The universal funding mechanism can be perfect if the funding is calculated and implemented every nanosecond. But when the funding cycle is stretched to 8 hours, a lot of things can happen right before and after funding payments are made. People may open a position 0.01 seconds before funding and close it immediately after receiving funding payments, leading to abnormal fluctuations around the time of funding.

If we take a step back, the funding mechanism is merely a bandaid slapped onto someone with a headache that is CEX-traded crypto options. The real hurdle that is holding so many exchanges back from introducing options is the lack of liquidity.

When you first look at it, crypto options seem a good instrument boasting similar open interest to perpetual futures:

Source: Coinglass

When in reality, the options market is divided into hundreds of sub-markets, each with a different expiration, strike price, and supply & demand. As a result, liquidity is fragmented into dozens of pieces and the spread on some sub-markets can be jaw-dropping. And that's just Bitcoin. Go to Bybit, the 2nd/3rd CEX, and look for options for Solana, the 4th largest crypto (not counting stablecoins) looking to surpass Ether, you'll find almost half of the sub-markets empty. Options are just too complex for investors without a systematic understanding of finance and investing, at least at first glance. It's not even friendly to market makers, as mentioned in Path dependency.

Looks like we must educate all traders about the benefits of options and invite them to trade these fine instruments. Markets can be made as long as there are enough traders. But that's just another bandaid on an even grimmer headache.

If you're looking to trade crypto derivatives, there are 2 places to go: CEX and DEX. CEXs are generally faster with more liquidity but you must go through an arduous KYC process and put your funds in the hands of others. DEXs give you more control and freedom but are not nearly as fast or efficient as CEXs. At its current state, blockchain will never be an ideal place for sophisticated or institutional traders commanding huge liquidity who would choose speed over decentralisation and permissionlessness any day. Many DEXs will look to centralise 1 or several links in their protocol such as order book, order matching engine, database, market makers and more to maximize efficiency and attract large institutions with deep pockets. As a result, centralised institutions will have more and more say in these protocols and in the end, they may just turn into on-chain CEXs where decentralisation is nothing but a name.

Such is the finance industry. When even the slightest edge may put you ahead and rake in billions of dollars, the survivors will look to build higher and higher walls and work with players from all walks to protect their interests. To a newcomer, the world of finance is as much a dark forest as Ethereum is although neither was designed to be initially. Uninitiated individuals will always get eaten alive in such a hostile environment while the survivors feed on their remains and grow into behemoths that are too big to fall. In the end, these financial giants will have immense fun playing with sophisticated, quadruple synthesised products like MBS in an extremely centralised walled garden while the outsiders will do anything for an entry pass.

Satoshi Nakamoto did invent Bitcoin to battle centralisation but now, the cryptocurrencies may just become another place where institutions take in individuals' funds and throw them one or two bones every now and then.

A look into the future

But the future is not all doom and gloom. There surely will be more brilliant minds trying to innovate on perpetual options and evangelising this financial instrument. Options that favour long-term investors with minimal arbitraging opportunities may be invented and blockchain is just an ideal place for them. Account abstraction may eventually bring in hundreds of millions of new users and with them, fragmented liquidity may not be a problem any more. Traders who value decentralisation and privacy will still get to play and grow their own games. A few boutique protocols may survive through the years and eventually be discovered by the masses.

Looking back, perpetual options may not even be the right answer we are looking for. They are one of the most important derivatives with a spark of crypto innovation but at its current state, it's merely a derivation from a traditional financial instrument that is as far from decentralisation as an empty bucket. To disrupt the old finance, we may need to build a new one from the ground up.

Please be advised that none of the above is financial advice.