Our options
Now that you understand the basics concepts of how regular options works, it's time to check our approach to DeFi Options.
As you read before, an option contract represents a right but not an obligation to the option buyer. On the other hand, the option seller makes a commitment to allow the buyer to exercise the option in case it wants to.
And we summarize those contract rules in what we call odTokens.
odToken is our primitive. It is how one issue, hold and transfer an option contract in the market.
How odtokens work?
odTokens represents the right of the buyer to exercise an option.
An option is issued when a seller decides to lock collateral and mint odTokens. That collateral can be any ERC20 token or aTokens. After odTokens are minted, they are sold on Uniswap for a premium, at market rate.
Since we are doing American options, the buyer can exercise the odTokens are any moment until expiration. If the buyer chooses to exercise the option, it will have to provide odTokens + underlying asset (in the case of a put option). When this happens, the buyer unlocks the collateral inside the contract and burn odTokens.
Our put options (aka podTokens)
Consider a put option for ETH:DAI, strike price 100, premium 3 DAI, expiration date May 30.
A put option for ETH:DAI represents the right but not the obligation of the buyer to sell ETH at strike price at any moment until expiration.
The notation ETH:DAI means that ETH is the underlying asset and DAI is the strike asset. Since this is a put option on ETH price, the collateral will be held in DAI.
The seller locks collateral in the contract, mint podTokens and sell them on Uniswap at market rate. The seller will receive the premium (3 DAI) and its collateral will be locked inside the contract until expiration (May 30). By locking collateral and agreeing to the contract terms (strike, expiry date, premium, American option) it is also agreeing to be exercised, if the buyer chooses.
In the case of exercise, the buyer will deliver podTokens + underlying asset back to the contract. The seller will receive ETH and those podTokens will be burned.
Notice that selling a put option, at a higher level, works as placing a buy order in the underlying asset because the option seller locks stable collateral and agreed with exchanging the stable collateral to the underlying asset at the strike price. The difference is that the user receives a premium upfront to do so.
That's why it makes sense to think of selling put options as buying the underlying asset at a discount.
Our call options (aka codTokens)
Consider a call option for ETH:DAI, strike price 250, premium 3 DAI, expiration date May 30.
A call option on ETH:DAI represents the right but not the obligation of the buyer to buy ETH at strike price at any moment until expiration.
The notation ETH:DAI means that ETH is the underlying asset and DAI is the strike asset. Since this is a call option on ETH price, the collateral will be held in ETH.
The seller has to lock collateral (ETH - underlying asset) in the contract, mint codTokens and sell them in Uniswap at market rate. The seller will receive the premium (3 DAI) and its collateral will be locked inside the contract until expiration (May 30). By locking collateral and agreeing to the contract terms (strike, expiry date, premium, American option) it is also agreeing to be exercised, if the buyer chooses.
In the case of exercise, the buyer will deliver codTokens + DAI back to the contract. The seller will receive DAI and those codTokens will be burned.
Notice that selling a call option, at a higher level, works as placing a sell order in the underlying asset because the option seller locks ETH as collateral and agree with exchanging the collateral for the strike asset (DAI) at the strike price. The difference is that the seller receiver a premium upfront to do so.
That's why it makes sense to think of selling call options as selling the underlying asset with a premium.
American options and physical settlement
Our options are set to be exercised at any moment until expiration and therefore, we are using American options format.
For cash settlements to work on a decentralized way, we’d need a price oracle to make sure the amount each party has to pay is correct and due. That would make us exposed to price oracles and liquidations. On the other hand, physical settlement assumes that all the collateral will be exercised, and that solution does not require a price oracle and liquidation system.
Specially if you keep in mind that in the case of a put option, it makes no sense to exercise an option that is out-of-the-money. For call options, thought, it represents a downside on its pricing.
A call option represents the right to buy the underlying asset at the strike price. If there is no price oracle, there is no way to know if the spot price actually got close to the strike price. Meaning that the price of a call option, when it’s a physical settlement with no price oracle, should not be less than the difference between the spot price with the strike price in order to avoid instant and pure arbitrage. We understand that this makes little sense for the usability of call options and we’ll improve this part of our contracts soon.
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