New yETH-PUT (Options) Strategy / Vault

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New yETH-PUT (Options) Strategy / Vault

Proposal by @ramaruro, @Estebank (Joint work)

Summary / Motivation

Create a new Strategy/Vault for yETH which will further increase existing yields by gradually adding liquidity to incumbent options markets. This is motivated by two main goals :

  • Develop an alternative strategy to earn ETH yield in addition to the current yETH vault strategy with the potential for even higher yields.
  • Provide liquidity to support and help grow the nascent Option Markets that are fundamental instruments to support further diversification in DeFi. It can become a virtuous circle for Yearn (earn good returns) and other Protocols (grow the market).

Abstract:

Create a yETH-Put Vault, with the main objective to have a net yield in ETH (as in the current yETH Vault).
The vault would take ETH, lock in Maker to Mint DAI and then use DAI in a dual strategy:

  1. Deposit DAI in a Pool to earn a relatively stable return (initially 90%+ should follow this strategy). It could replicate the current yETH strategy for this portion, or deposit DAI into Swerve.
  2. Sell ETH Put Options (Vault sells Price insurance on ETH) to diversify earning approach and increase yield (start with 10% or less liquidity in this strategy and increase it gradually as demand grows)

Initial yield should be similar to current yETH Vault, with a huge potential to exceed it, while providing a diversified approach.

An additional outcome is that it will provide liquidity into the nascent Option Market, which is a very important Financial Instrument for the DeFi ecosystem. Yearn stepping into the Option Market can be a strong partner to help develop the Options Market and make the DeFi ecosystem stronger. This would be in the same spirit as the current collaborations with AAVE, Curve, Nexus Mutual, Rarible and others.

ETH yield would grow always, yet not necessarily a net yield in Fiat, as that would depend on the evolution of price of ETH.

This graph illustrates the key points:

yETH-PUT options Strategy recap
yETH-PUT options Strategy recap1413×1468 227 KB

Specification:

Should this proposal be implemented, a yETH-Put Vault will be created. This Vault would deploy two strategies, with the weight of each strategy being adjusted over time as the Liquidity of the Option Market increases and the Risk Exposure is better “Tested in Production”.

To start, ETH is deposited into the Vault, it is locked in Maker to mint DAI at a 200% Collateralization Ration (C-Ratio). The resulting DAI would be used in two Strategies to earn a return:

  1. Deposit DAI in a Pool to earn a relatively stable return:
    • e.g. replicate the current yETH strategy: DAI → Curve Pool → Earn CRV → Sell CRV → Buy ETH
    • e.g. same yETH strategy on Swerve (http://ipfs2.swerve.fi/#/swusd): DAI → Swerve Pool → Earn SWRV → Sell SWRV → Buy ETH
  2. Sell ETH Put Options with a Strike Price close to the Price that ETH would be bought in Strategy 1. The two possible outcomes are:
    • Keep the Put Premium because the Put option expires worthless or is not exercised → Earn a Yield on the Collateral that secured the Put.
    • Get assigned (i.e. the Put is exercised), so the Vault buys ETH at the predetermined Strike Price, but effectively, at the Strike Price – Put Premium, so it buys ETH at a lower price than it would have originally.

There are two alternative Option Protocols identified as candidates to use for this Strategy:

Opyn:

The Vault would have to mint specific Strike/Expiration Combinations that then are offered on the Opyn Website for Customers looking to buy Put protection on ETH price (Yearn (https://yinsure.finance/add) already offers insurance based on Opyn).

Upside of this Protocol:

  • the result is either more USDC if not assigned (Collateral needs to be posted in USDC, not DAI) or ETH at a more convenient price (if assigned).
  • Protocol is open source and shows flexibility for more products.
  • There are currently no fees involved from Opyn.

Downside of this Protocol:

  • Puts have to be purchased by somebody to effectively earn the yield.
  • It could happen that a Put series is minted and there are no buyers, effectively not providing any yield.

Hegic:

The Vault would provide DAI Liquidity into the DAI pool which is used as collateral for Users that can mint any Strike and Duration combination that they may like.

Upside of this Protocol:

  • It is more flexible for the Put Buyer and more flexible for the Vault, as it only requires providing Liquidity into a Pool.
  • Also there is a Liquidity Incentive Program that was just launched (September 9, 2020) so there are HEGIC tokens earned (for the next 3 years), which can be market sold for higher returns or staked for further rewards.

Downside of this Protocol:

  • The Liquidity Pool is denominated in DAI. If there was a consistent downward trend of ETH price or a black swan event, the net result in DAI could be negative. Given the current incentives with the Liquidity Mining Program, this might be counteracted.

Final Notes:

  • Options Market is huge in Tradfi, and very lucrative. In Defi it is incumbent, liquidity and demand still small, which is a great opportunity.
  • Call option is another proposal which we are in the process of elaborating.
  • We have contacted the Opyn team (Alexis Gauba and key developers) and they are open to collaborate on the contract side and other aspects.

References:

40% of tokens will be allocated on the Liquidity Mining & Utilization Rewards contracts. Liquidity providers and options holders will be receiving HEGIC tokens during a three years long M&U rewards program.

  • Liquidity mining & utilization rewards: 1,204,809,000 HEGIC (40%)
  • Rewards allocation: 80% — liquidity providers, 20% — holders
  • Rewards in HEGIC tokens: 963,847,200 (80%) / 240,961,800 (20%)
22 Likes
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Interesting. Would be awesome to see yearn play a role similar to that of an options dealer in traditional markets. In the traditional markets the options dealers are always looking to hedge their gamma exposure from selling the options. Would be interesting to develop a similar strategy where the vault is always looking to maintain a hedged options portfolio while collecting the premium by selling both call and puts. Curious how this would map to the defi world. Has potential to be very powerful.

5 Likes
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Vinicius Melo from Auctus here, the project responsible for developing ACO protocol, we are currently finalizing and testing our AMM model based on BSM. It will have many advantages compared to using Uniswap. Our system will be able to offer liquidity for any combination of existing strike/expiration options.

Glad to see this proposal because this is similar to what we had in mind for doing once our AMM model is live, our idea was actually to use yields to purchase call options (yETH-BULL, crvBTC-BULL, etc). We would love to collaborate and help to create yEarn strategies using options, we would also be able to offer liquidity mining incentives.

9 Likes
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First time I read about options in crypto. Interesting!

I am a bit concerned of the risk of selling a put. What if instead of selling a put, the vault buys a call to freeze purchase price in a future day whenever we generated enough profit to exercise?

Buying instead of selling would limit the risk.

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Collapse in ETH price would be brutal while short puts in the vault (tail risk).

Are you able to hedge against collapse on any of the protocols by buying out of the money puts in addition to selling at the money?

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Or do we have any form of decentralized futures for hedging?

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This sounds interesting, would love to see yearn explore this space.

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Awesome stuff. How about flipping the idea with gaining a put option and paying for the theta (option premium by farming enough yield to cover)…there by creating a hedge for the ‘HODL’ ETH position…

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A collapse in ETH price would lead to more losses in the Hegic approach (Liquidity Pool). For the Opyn approach, selling specific puts to a buyer, as the position needs to be fully collateralized, it would not create a problem. However there would need to be a partial unwinding of the original DAI position minted in Maker, as the C-Ratio would fall below the threshhold.
That is why this Vault needs a dual strategy approach, as full exposure to short puts with DAI minted from the original ETH (i.e. already leveraged) would be too risky.

There are other considerations to reduce risk (and upside) that could be included like buying lower strike puts or sell some calls.

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Yes, Yearn could be a powerful player in the Options world. There is very little volume so far, but I think this is a big growth area and an great opportunity for Yearn to help develop it and profiting from it at the same time, a win - win situation.

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That could be a different and very valid strategy, but in that approach the yield would be reduced (spend premium on the calls vs earning it), but it would be less risky too.

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It’s a nice proposal, simple and straight to the point. Selling covered puts is perfect for yETH vaults because it earns premium and lets us buy more ethers at lower prices (if we are assigned).

I am proposing to use Primitive for this strategy. I was planning to submit a proposal myself with the same strategy in mind, but I am glad you two beat me to it.

Primitive:

The vault would choose a put option contract that is already deployed, or create its own option with its own decided strike date and expiration. For ether puts on Primitive, Dai is the collateral asset. The yearn vault would mint Dai through maker, and deposit a portion of that Dai to mint ether puts, which can then be sold to another party for premium.

Upside of this Protocol:

  • Oracle-less because of physical settlement.
  • Permissionless; yearn gov or the strat itself could manage its own option market or plug into an existing one. (By option market, I mean some option with a certain strike date/expiration).
  • No fees.
  • Flash exercises are built into the option instruments themselves, so the underlying collateral can be used to pay its strike price.
  • Ether puts are minted with Dai, ether calls are minted with ether. This strat mints Dai from Maker so it can go directly to minting puts to sell.

Downside of this Protocol

  • Physical settlement means 100% collateralization; capital inefficient.
  • Puts would need to be purchased by some party through some exchange (whether that be a CFMM or some dex).
  • Contract is not battle-tested.

Notes
Primitive is not live on mainnet, yet. It will be soon. However, the contracts are built in a way to offer flexibility for wrapper contracts to build on them (e.g. yearn strategies). Not only could yearn bootstrap some basic option liquidity, but also build new strategies that specifically use options for certain exposures (i.e. short gamma).

Also, I am very excited to be contributing to any yearn related endeavor! :grin:

7 Likes
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The returns of selling out of the money puts follow a Taleb distribution, producing slow, steady returns punctuated by rare, sudden, massive drawdowns. Since naive observers tend to look at recent / historical returns only, it is not uncommon to use such a strategy to bamboozle investors about risks. Prof. Andy Lo created the fictional hedge fund Capital Decimation Partners LP to illustrate the risks of such strategies. He writes:

Shorting deep out-of-the-money puts is a well-known artifice employed by unscrupulous hedge fund managers to build an impressive track record quickly

Yearn vault tokens can already be used as collateral for loans at CREAM, so there is a clear path for sophisticated or risk-loving investors to add leverage, which they can use to engage in options plays if they so desire. Explaining the risks of the current strategies to new investors is hard enough; I don’t think this strategy is appropriate for the general public.

@mikeyrf mentions the possibility of using a short put spread, which could be used to manage risk, but it is not clear if that is feasible after trading costs and price spreads.

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Selling puts that are secured by collateral (in tradfi - cash secured puts) is actually less risky then buying options- especially call options. When combined with a multi-strategy approach (as collateral/secured puts caps your maximum upside to the initial premium received for writing the contract) I would suggest first attempting bolting on this strategy to the existing yETH vault as another method of acquiring ETH. Primarily due to the lower liquidity (for right now). Very interesting idea and can also say in Tradfi with cash secured put writing has led to lower volatility with increased returns over tradfi indexes (Nasdaq/S&P 500).

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if you assume that the vault will always hold enough eth to cover.
My point is buying options has a limited risk (value of the premium), selling is not limited.

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Interesting point and why Mark Spitznagel’s Universa (Taleb is an advisor) - did so well… Long Term Capital also comes to mind as to how even academics can ignore ergodicity…

Options, if used correctly (understanding that they provide an ability to structure a risk-return profile, not just speculation) could offer multiple levels of defined outcome (max loss/max return) vaults. This could actually be where multiple vaults (those folks looking for a lower risk/return or hedging tail-risk) would create demand for other vaults seeking a higher risk/return (or to vaults looking to acquire additional ETH - that is, selling options with strike prices below current price with secured collateral in DAI or another stablecoin). In my view this is compelling instead of using CREAM as the options implementation would be part of the vault system.

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yes - maximum loss for buying options (call or put) is based on initial premium paid; for selling puts its maximum profit is limited to initial premium received and max risk is asset price going to zero (I would say that there is a way to mitigate using a spread [selling a put with a strike price closer to current market price with buying a further out of the money [strike price further away from current market price] to set a floor for maximum risk]. With selling call options, which I would say is the highest risk and most susceptible to going wrong - max gain is again limited to premium received from selling contract and max risk in theory is unlimited [on the hook to buy ETH at whatever price it is].

creating another options market versus integrating with other platforms like Opyn and Hegic - i would say - work with existing option providers…

with Nexus Mutual and ability to have cover - there is so many things these vaults can do. human emotion I feel is the greatest detriment to options (lack of understanding, desire to go against one’s own rules, increasing risk due to complacency).

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Thanks for the comments and agree if mismanaged and/or miscalculated.

Covered Put writing, i.e. fully collateralized as is required by Opyn is not more risky as you define full exposure from the beginning. However, when using he Liquidity Pool for option writing (which is a more probable approach), you have less control initially in terms of exposure, but in that approach the vault could also buy lower strike put options and or other strategies to mitigate, as the vault would have full control on the specifics strikes desired, without depending on a seller to write that specific option.

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Thanks Alexander, I appreciate your comments, obviously you have a great understanding of the Options Protocol in DeFI; it would be interesting to explore Primitive as an alternative for managing the Options.

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With secured puts, the draw-down here would be a repurchase of ethers at lower prices, which is not a complete downside for the vault. What risks are you thinking of?

Also, that paper by Prof. Lo looks interesting so I’ll have to read it.