Liquidity Pools

Each underlying asset has two distinct liquidity pools: one comprising the quote tokens and the other the base tokens. For instance, in an ETH/USDC pairing, ETH is the base, and USDC is the quote currency. Liquidity providers can choose to participate in one or multiple of these pools based on their market perspective. This means that if the liquidity provider wants to have an upside in ETH or wants to limit the risks of crypto changing its price (keeps USDC), he/she can participate in the pools whilst keeping the desired currency.

When you stake in Carmine Option liquidity pools, you facilitate users' interactions with the AMM by assuming the counter-position to their options trades. The volatility update mechanism adjusts the options price—increasing it if an option was bought, decreasing it if sold—to prompt users and arbitrageurs to offset the liquidity pool's exposure.

This means that if users (traders) are buying options, the pool(s) will be short in options, making the pool short volatility. If the users (traders) are selling options, the pool(s) will be long in options, making the pool long volatility. Because of the design, where the AMM incentivizes arbitrageurs to take care of the inefficiencies, the positions of pools might not be 0 but should be close to that.

Risks for liquidity providers

The pool's design is meant to hold exposure briefly, until arbitrageurs offset any considerable accrued exposure from the liquidity pool. Liquidity providers face risk during instances of sudden spikes in implied option volatility (e.g., market shocks), where arbitrageurs could trade against the pool. This risk is mitigated by establishing per-trade limits, maximum pool size, and careful monitoring of the pool's exposure and consequently adjustment of pricing parameters. Ultimately, liquidity pool contributors are betting that fee revenues will more than compensate for potential losses during periods of swift implied option volatility fluctuations.

The quote pool facilitates put options, while the base pool handles call options, thereby determining the currency in which options are settled. Each liquidity pool also features a 'constant adjustment volatility speed' which regulates the rate of volatility change within a pool. A constant is also employed to limit the maximum trade size—for instance, a trade is currently capped at 20% of the corresponding liquidity pool size.

In essence, liquidity providers sell options to users (or buy options from users) and thus are on the „other side“ of the deals. Volatility could spike, with it option prices and the liquidity pool will be arbitraged. It is very unlikely that the LPs would lose their whole stake. The liquidity pool tries to get rid of its exposure by adjusting the pricing, but isn't always successful, especially now, when there's a severe lack of supply in the liquidity pools.

Pricing of LP tokens when entering/exiting your stake in the pool

You can enter and exit the pools instantly at any time as long there's enough available capital not locked in options in the pool. When you contribute to a pool, the pool's value is computed as the sum of the values of all options held by the pool, determined via the Black-Scholes model (excluding fees), plus all cash retained by the pool. When a user pays premiums to purchase an option from the pool via the AMM, the pool receives these premiums, which count as cash, and assumes the counter-position, valued according to the pricing model.

Liquidity pool composition

The liquidity pool is made up of both unlocked capital, which can be withdrawn by liquidity providers (LPs) or used to write new options, and locked capital, which serves as collateral for short options. A distinctive feature of our liquidity pool design is its balancing act - consider a scenario where users sell 1 option, buy 2 options, then sell 1 option again (assuming the same expiry and strike). In this case, the liquidity pool's exposure is neutralized, leaving only the fees - a profit for the LPs.

Liquidity pool positioning as of April 2024

Currently, the demand for long/short options is quite balanced leaving the pools with very little exposure relative to the TVL.

Historical liquidity pool positioning as of June 2023

In June 2023, there was high demand for purchasing options through the AMM, causing an increase in option prices. This situation results in attractive APYs for the liquidity pools, but it also leads to short options and thus short volatility exposure. To monitor the recent APYs, refer to the 'Staking' page within the app.

Short volatility exposure, while very profitable in stable markets due to decreasing option prices, comes with risks. In particular, if volatility rises, larger price swings could result in substantial losses as the price of the sold options increases. The unpredictability of volatility, influenced by macroeconomic factors and asset-specific events, adds an additional layer of risk. The complexity of risk management with rapid market movements necessitates constant monitoring and potential adjustments. Additionally, being short options involves gamma risk, which becomes riskier as the underlying asset price nears the option's strike price. Thus, robust risk management strategies are vital when engaging with short volatility exposure.

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