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Example 1: User wants to gain profits from token's increase in value. User buys call option.
Example 2: User belives token is overpriced but doesn't want to risk making a mistake. User sells put option.
Example 3: User hedges its portfolio.
Example 4: User trades volatility.
Example 5: User hedges its loan against liquidation.
Example 6: User hedges its staking in standard AMM.
Example 7: Hedging game commodities against outer world (ETH, USDC,...)
Example 8: Hedging NFTs
User believes that price of ETH will grow in respect to USDC, but is risk averse and doesn't want to risk potential losses. User buys 2.5 Call options on ETH/USDC with strike 3500 USDC and current price 3000 USDC with option premia 30 USDC with maturity in 1 month.
- At the start the user pays to the pool equivalent to 2.5*30 USDC in ETH, which is 75/3000 ETH = 0.025 ETH for the call options. The pool locks in 2.5 ETH.
- At maturity there are two possibilities
- Current price is above the strike, lets say 3700USDC. The options exercised in the money. The user get equivalent to 2.5 * (3700 - 3500) USDC = 500USDC in ETH, which is 500/3700 ~ 0.135 ETH. The rest of the locked capital 2.5-0.135 = 2.365 is returned back to the pool.
- Current price is below the strike, lets say 3300USDC. The current price is not above strike price so the buyer gets nothing and all the locked capital is returned to the pool.
User sells 1 Put option on ETH/USDC with strike price 2600 USDC and current price is 3000 USDC with option premia 40 USDC with maturity in 1 month.
- At the start the user receives 1*40 USDC = 40 USDC as premia from the pool and locks in 2600 USDC.
- At maturity there are two possibilities
- Current price is above the strike, lets say 2800 USDC. Which means that the buyer (pool) does not receive anything and the seller (user) get back its locked capital of 1 ETH.
- Current price is below the strike, lets say 2500 USDC. The option is exercised in the money so the the buyer (pool) receives 1 * (2600 - 2500) USDC = 100 USDC and the seller (user) gets its locked capital without the 100 USDC back, ie 1 * (2600 - 100) USDC = 2500 USDC.
User wants to hedge its portfolio that consists of several alt coins, he/she is willing to absorb 20% decrease in the value, but no more. The porfolio together is equivalent to 20ETH or 60 000 USDC. The user believes that his if the portfolio will go down, ETH/USDC will go down in price too and by the same proportion. User wants to have this hedge for the next 3 monts.
User wants to cover potential loss from the portfolio, he/she decides to buy put options. Current price of ETH/USDC is 3000 USDC and since user is willing to accept 20% loss he/she selects the strike price 2400 USDC, the price of put options at 2400 USDC and 3 months maturity is 130 USDC.
- At the start user pays 20 * 130 USDC = 2600 USDC for 20 put options to the pool and the pool locks 20 * 2400 USDC = 48 000 USDC in put options.
- At maturity there are two possibilities
- Price of ETH/USDC stays above the strike price. User (buyer) does not receive anything and the pool gets back its locked capital.
- Price of ETH/USDC decreased below the strike price, to lets say 2100 USDC. The option is exercised in the money so the user (buyer) receives 20 * (2400 - 2100) USDC = 6 000 USDC to cover its loss. The pool receives rest of the locked capital back (48 000 - 6 000) USDC = 42 000 USDC.
- In case the user's portfolio behaved in value same as ETH the user covered its excess loss with the options and the current value of the portfolio is equivalent to (2100/3000) * 60 000 + 6 000 USDC = 48 000 USDC and the user suffered the 20% loss which is the maximum he/she was willing to take on.
User believes that the volatility will be higher than the market is currently pricing it in so he/she decides to long strangle option strategy.
Long strangle consists of one long put and one long call with hight strike price than the put. Current price is 3000 USDC for ETH and the user decides to buy the put at strike 2600 USDC and the call at 3400 USDC both with 1 month maturity. The put costs the user 35 USDC and the call 30 USDC for contracts equivalent to 1 ETH.
- At the start user pays 0.01 ETH (30 USDC in ETH) for the call option and 35 USDC for the put option. Pool locks 1 ETH in the call and 2600 USDC in the put option.
- At maturity 3 possibilities can happen.
- Price of ETH is below the put's strike price, lets say 2400USDC. The put option is exercised in the money and the call expires with no value. User gets 1 * (2600 - 2400) USDC = 200 USDC and the pool gets back 2400 USDC from the locked capital in the put option and 1 ETH from locked capital in the call option.
- Price of ETH is between the options strike prices, lets say 3100 USDC. Both of the options are out of money and expire with no value. User gets nothing and pool receives back its locked capital of 2600 USDC and 1 ETH.
- Price of ETH is above the call's strike price, lets say 3500 USDC. The put option is out of money and expires with no value and the call is in money. User gets from the call option equivalent to 1 * (3500 - 3400) USDC = 100 USDC in ETH, which is 100 / 3500 ETH ~ 0.02857 ETH.
Imagine having a loan, depositing 1 ETH and borrowing 1500 USDC. The price moves from 2250 USDC (at the moment of lending) down to just below 1875 USDC so that your health factor decreases just below 1 and you get liquidated. The liquidation costs you 5% of the liquidated value, where usually half of the borrowed capital gets liquidated. The liquidator repays 750 USDC receives bonus and gets (750 + 750 * 0.05) = 787.5 USDC worth of ETH = 0.42 ETH and you are left with 0.58 ETH deposit, 750 USDC borrow amount and 1500 USDC, which in sum is equivalent to 0.98ETH or 1828.5 USDC.
In case you measure the value of your portfolio you lost 421.5 USDC in value. If the price keeps falling you will be liquidated more and more and more, losing even more capital.
- At the start value of your assets is 1ETH + 1500 USDC - 1500 USDC = 1ETH = 2250 USDC
- After first liquidation the value is 0.58 ETH + 1500 USDC - 750 USDC = 0.98 ETH = 1828.5 USDC
- After second liquidation the value is 0.37 ETH + 1500 USDC - 325 USDC = 1.096 ETH = 1770 USDC
- After third liquidation the value is 0.21 ETH + 1500 USDC - 162.5 USDC = 1.42 ETH = 1569 USDC
Since the risk comes with decreasing price (if the borrow and deposited tokens were switched it would be with increasing price) the user can hedge with a put option at a strike price 2400 USDC and size 1.5 ETH. At the price of the first liquidation, the option will have at least the following value (1.5 * (2400 - 1875)) USDC = 787.5 USDC equivalent in ETH, which is 0.42. If the user does not add additional deposit, next price where the user gets liquidated is cca 1616 USDC where the liquidator repays 325 USDC and gets cca 0.21 ETH which total in 0.63 ETH decrease of your collateral and 480 USDC decrease in value of your capital. At the price of second liquidation the option will have at least the following value (1.5 * (2400-1616)) USDC = 1176 USDC equivalent in ETH, which is 0.73 ETH.
Imagine the following scenario. You stake AMM with 5TOK (general token) and 500USDC so the pool has (after your stake) 100TOK and 10 000 USDC (you own 5% of all staked capital). This is equivalent to (5 * 100 + 500) USDC = 1000 USDC or 10 TOK. The pool size implies that the price of TOK is 100 USDC.
- There is some trading going on (for simplicity with no fees) and the price goes to 200 USDC.
- Because of constant product function the AMM uses, the token distribution is cca 71 TOK and 14142 USDC.
- You own 5% of the pool so now you own 3.55TOK and 707.1USDC, if converted to USDC (3.55 * 200 + 707.1) USDC ~ cca 1414 USDC or cca 7.1 TOK
Now to compare the initial 1000 USDC to 1414 USDC. In terms of USDC you made profit of cca 414 USDC but in terms TOK you made loss (10 - 7.1) TOK = 2.9 TOK.
If the price went down, instead of up, you would make loss in terms of USDC and profit in terms of TOK.
Since you care mainly about your value in TOK you hedge against the price increase against capital losses from it. In this case you can buy 5.8 call options at a strike 100 USDC. In the moment the price reaches the 200 USDC mark, you call option has value (5.8 * (200 - 100)) USDC = 580 USDC equivalent to 2.9 TOK which covers your risk.
Since you care about the value of your capital in TOK (and not in USDC) you can offset the cost of the call options by selling same amount of put options at the same strike price and maturity.
Similar thing could be done with put options if you cared about balance in USDC and not balance in TOK.
Imagine you buy an ingame commodity for x ETH or USDC and the commodity loses its value in comparison to this to ETH or USDC, because of external factors. So when you sell the commodity you get less, than you paid for it. This can be hedged.
Each game has some level of inflation/deflation between ingame commodity and outer world tokens (ETH, USDC,...). It is either through in game currency vs outer world where ingame commodities are relatively stable against this ingame currency. Or this is happening directly between the ingame commodities and outer world (ETH). The second case you can imagine having a basket of ingame commodities (index) that has some value against ETH.
Both of these cases can be simply hedged with options. Covering the above mentioned risk of ingame commodities losing value against ETH or USDC or something else. The options are basically another building block for building and stabilizing game economies.
More specifically hedging can be done with long put option on for example GAME_TOKEN/ETH or GAME_INDEX/ETH at a strike that corresponds to risk aversion of user and long enough maturity.
Similarly to previous example investors can be hedging their NFT investments.
Simple buy a put option on NFT index in a similar size to user's portfolio at a strike price that corresponds to the level of user's acceptable risk.