“When you have exhausted all possibilities remember this…you haven’t” — Thomas Edison
As many have pointed out there are several striking (forgive the pun) similarities in creating option strategies between AMMs (automated market makers) set on CoinFLEX.com or Uniswap V3 (when both are set in a range mode) and traditional vanilla options.
Guillaume Lambert explains it well in his medium piece (link below) but I wanted to simplify it even further for general futures and passive income traders.
What is a Covered Call?
In a traditional vanilla options trade, an investor with the long underlying may want to earn yield by selling call options against this long and profit by generating yield from the premium earned by selling this call. Using Bitcoin Cash (BCH) as an example, he owns BCH (currently trading $500) and aims to earn yield by selling the September $550 BCH calls at say $50. If BCH:
- Stays between $500 — $550 by the expiry date (September), then he collects the premium on these short calls, $50 (ignoring fees)
- If BCH goes lower, he keeps the premium on these calls ($50) but loses money on his underlying long portfolio
- If BCH moves higher and past $550, the most he can make is the difference between the premium of the call and the P&L of underlying moving from $550 to $600. Above $600 ($500+$50) he generates no money as the P&L he makes from the long BCH spot goes to paying the P&L of the long option buyer. Now if BCH goes back below $550, then he stops paying out to the options holder and starts earning money (the premium) himself.
How Can This Be Similarly Structured in AMM+?
Well, if you select “Sell Only mode” on CoinFLEX and then say you select the sell only range from $530–550 you have a few advantages and disadvantages over a vanilla call sale:
- The range between $530 and $550 allows the LP (liquidity provider) to potentially trade multiple times back and forth and earn fees as opposed to being a bullet expiry with vanilla options. This means that the yields you get from having this LP token in place could be significantly higher in returns than a single short option premium due to all the fees (exchange fees and profit and loss from the realised $) collected during this period.
- These ranges assigned to the LP tokens are in fact perpetual in nature and so can go on collecting yield as long as the investor needs (pre redemption). This is an extremely interesting way of addressing the question of how perpetual options can be designed. Perpetual options are something currently being discussed in crypto as a way of expanding the usage of options by retail traders. This is due to the intrinsic difficulty and costs (knowledge, liquidity and options rolling costs) of trading vanilla options on Deribit or Bit.com. However, perpetual options are just theoretical at present (AFAIK) and are potentially a long way away (if ever) from wide scale adoption. Creating this same base effect with LP tokens using AMMs is far easier, immediately usable today and a scalable use case which replicates this feature. The scale comes from tapping into the single largest market in crypto, that being perpetual futures.
- BCH may not move to that target range of $530-$550 and so with the AMM product the NFT will not earn any income. With vanilla options, the short premium is earned immediately upon execution. However, one strategy that you can achieve with AMM’s is to create a series of option sales across all “strikes”. For example, BCH is trading at $500 and if you want to buy the dip (by selling put options), you can select a buy only range from $450–500 and in effect you have sold a series of puts from $500 down to $450. This gives you way more premium than just selling the $450 strike.
- As such it is possibly best to deploy covered call and covered put transactions (using the “Buy Only” mode on CoinFLEX’s AMM+) when designing close to the money option premium collecting strategies as they are way more effective using AMMs as opposed to vanilla options.
Other Options Strategies that Can Be Replicated Using AMM+?
So we have seen how you can replicate a covered call or put strategy using LP tokens. The intrinsic nature of AMM’s is that you are selling gamma or volatility. This is as you are blindly placing orders to trade and you make the most money in two ways markets. As the market rallies, you will get shorter and shorter (hence short gamma/volatility) and you make money with the market returning to its original level — all very similar to a short strangle or short straddle trade/position.
So How Do You Replicate a Short Straddle/Strangle Using AMM+
Pick a neutral range around the at the money and now profit from mean reverting range bound markets. If the market breaks significantly outside one side of the market and stays there, you now have impermanent loss (IL) risk.
Some crypto options traders may argue that attempting to replicate options strategies using AMM+ may be creating unnecessary complexity.I would tend to disagree for a couple of strong reasons that will resonate with anyone who doesn’t have deep options expertise:
- The liquidity from layering above these liquid swap pairs creates an opportunity for traders to build huge synthetic options positions without moving volatility in the underlying vanilla options markets where one large whale order oftens moves prices and destroys liquidity significantly. Simply put, options in crypto are extremely illiquid today.
- Many of these options specialists exchanges only offer a handful of options pairs, typically BTC & ETH. Using CoinFLEX’s swaps pairs, the world of tradable assets and liquidity grows tremendously with potentially hundreds of swap pairs creating yield opportunities.
- Via AMM you get to construct perpetual options. Being long a perp swap is already really a synthetic long call option. If you are long a $0 strike call option (deep in the money), you are in the same position as being a long perp swap with the underlying in the money value of the call option being exactly the same price of the perp price (there will be next to no time value for these options). Furthermore, on CoinFLEX and other crypto exchanges, you can only lose the money in your account and as such you have limited liability. This is the same as a long call option where the most you can lose is your premium paid.
- Creating these short options strategies on CoinFLEX’s futures markets are potentially way more lucrative from a returns/yield perspective than similar strategies on Uniswap V3. That’s simply due to the fact that:
- Trading frequency and volumes on central order books can be multiples that of Uniswap where there are limitations with the 12 second blocks on Ethereum.
- Leverage can be used by both the AMM and the taker, thereby juicing returns by streaming capital efficiency.
- No risk of front running on central order books as there is no risk of MEV (miner extractable value)
- You have no heavy fee leakage as there are no gas fees.
- Finally, by using vanilla options sales versus AMM synthetic options, you have a difference in payoffs where with vanilla options the yield is a fixed return (premium collected by selling the option) as compared to AMM returns, which are a floating rate return, as its path dependant on BCH or the underlying chosen.