Original Article Title: Trading Optionality

Original Article Authors: Sumanth Neppalli, Joel John, Decentralised.co

Original Article Translation: Luffy, Foresight News

Remember Sam Bankman-Fried? He used to work at Jane Street and later became infamous for his "effective altruism" experiment and misappropriation of funds. In the past month, Jane Street has been in the news for two things:

One is being accused of assisting in a coup (allegedly); the other is conducting arbitrage trading experiments in the Indian options market (also allegedly, after all, I can't afford lawyers who can beat them in court).

Some of these trades were of such large scale that the Indian government decided to completely ban Jane Street from operating in the country and seized their funds. Matt Levine provided a brilliant summary of this in his column for Bloomberg; in short, the operation of this "arbitrage" is as follows:

1. Sell put options in a liquid market (e.g., $100 million scale);

2. Slowly accumulate the underlying asset in an illiquid market (e.g., daily volume of $10 million).

In markets like India, the options trading volume is often several times that of the underlying stock. This is a market characteristic, not a loophole. Even if the underlying asset is insufficient, the market can always find liquidity. For example, the total amount of gold ETFs far exceeds the actual gold reserves; or like the 2022 GameStop stock price surge, partly due to the scale of its short position exceeding the number of outstanding shares. But I digress, back to the Jane Street case.

When you "buy" a put option, you are betting that the price will drop, or in other words, you are buying the right to sell the asset at an agreed price (i.e., the strike price). Buying a call option is the opposite: you are buying the right to buy the asset at a predetermined price. Let me explain with an example of the upcoming PUMP token.

Assuming that I bet the fully diluted valuation (FDV) of the PUMP token at launch will be less than $4 billion (perhaps out of disdain for venture capital and the meme market), I would buy a put option. Those who may sell me the option could be venture capitalists holding PUMP token allocations, believing that the price at launch will be higher.

A venture capitalist selling a put option will receive a premium. For example, if I pay a $0.10 premium and the token's listing price is $3.10 while my strike price is $4, then by exercising the put option, I can make a profit of $0.90, resulting in a net profit of $0.80 after deducting the premium. The venture capitalist is then forced to sell the token at a price lower than expected ($3.10), effectively bearing a loss of $0.90.

Why would I do this? Because of the extremely high leverage: I invest $0.10 to short $4 worth of assets. How can I achieve such high leverage? It's because the option seller (venture capitalist) believes the price won't drop below $4. What's worse is that the venture capitalist (and their network) may buy PUMP at $4 to ensure the price stays at $4.5 at the time of exercise. This is exactly what the Indian government accused Jane Street of doing.

Source: Bloomberg

However, in Jane Street's case, they weren't trading the PUMP token. They were trading Indian stocks, specifically the NIFTY Bank Index. Due to the high leverage in that market, retail traders often trade options. All they need to do is this: buy some of the underlying stocks with lower liquidity that constitute the index.

Then, as they buy the spot to drive up the index, sell call options on the index for a higher premium, buy put options on the index, and finally sell the stocks to pull down the index. Profits come from the call option premium and put option gains, with spot trading possibly resulting in a small loss, but the put option gains usually enough to cover that loss.

The infographic explains how this trade works: the red line is the index trading price, and the blue line is the option trading price. Essentially, they are selling options (depressing prices, collecting premiums) and buying the underlying asset (inflating prices, without paying for the option) — everything is arbitrage.

What does this have to do with today's topic?

It has nothing to do with it. I just wanted to clarify the concepts of put options, call options, and strike price for those who are new to these terms.

In this issue, Sumanth and I discuss a simple question: Why hasn't the cryptocurrency options market taken off? With Hyperliquid leading the narrative, on-chain perpetual contracts heating up again, and stock perpetual contracts about to launch, what about options? Like most things, we start with a historical background, then analyze the operational details of these markets, and finally look ahead to the future. Our assumption is: if perpetual contracts can gain a foothold, the options market will also develop.

The question is: Which teams are developing options products? What mechanisms will they adopt to avoid repeating the mistakes of the 2021 DeFi Summer?

We currently do not have a clear answer, but we can provide some clues.

The Puzzle of Perpetual Contracts

Remember that pandemic? That time when we sat at home, speculating on how long the large-scale social distancing experiment would last – the "good times." It was during that time that we saw the limitations of the perpetual contract market. Like many commodities, oil has a futures market where traders can speculate on its price. However, like all commodities, the value of oil is only realized when there is demand. The restrictive measures imposed due to the pandemic led to a sharp drop in demand for oil and related products.

When you buy futures for physical delivery (non-cash settlement), you acquire the right to receive the underlying asset at a predetermined price in the future. So, if I go long on oil, I would "receive" oil when the contract expires. Most traders do not actually hold the commodity but sell it to entities with logistical capabilities (like tanker trucks) or counterparties.

But in 2020, things went haywire. No one wanted that much oil, and traders who bought futures contracts had to bear the storage responsibility. Imagine this: I'm a 27-year-old analyst at an investment bank, but now I have to take delivery of 1 million gallons of oil; the compliance officer who is in their 40s would surely make me sell it all off first. And that's precisely what happened.

In 2020, the price of oil briefly plummeted to negative values. This vividly illustrated the limitation of physical futures: you have to take delivery of the goods, which comes at a cost. If I am just a speculative trader betting on the price of oil, chicken, or coffee beans, why would I want to take physical delivery? How do I get the goods from where they are produced to a port in Dubai? This is the structural difference between cryptocurrency futures and traditional futures.

In the cryptocurrency space, taking delivery of the underlying asset is virtually costless: just transfer it to a wallet.

However, the cryptocurrency options market has yet to see a true explosion. In 2020, the US options market saw a volume of around 7 billion contracts; today, that number is close to 12 billion, with a nominal value of about 45 trillion USD. The US options market is about 7 times the size of the futures market, with nearly half of the trades coming from retail investors who are keen on short-term options expiring the same day or over the weekend. Robinhood's business model is built on this: providing a fast, convenient, free options trading platform and profiting through the "payment for order flow" model (where market makers like Citadel pay).

But the situation is starkly different for cryptocurrency derivatives: Perpetual contracts trade volume is about 2 trillion USD per month, which is 20 times that of options (approximately 100 billion USD per month). The cryptocurrency market did not inherit the existing model of traditional finance but built its ecosystem from scratch.

The regulatory environment has shaped this difference. The traditional market is constrained by the U.S. Commodity Futures Trading Commission (CFTC), which requires futures to roll over, introducing operational friction. U.S. regulations cap stock margin leverage at around 2x and also prohibit "20x perpetual contracts." As a result, options have become the only way for Robinhood users (such as retail investors with only $500) to translate a 1% Apple stock price swing into over 10% returns.

The unregulated environment of cryptocurrencies has created space for innovation. It all started with BitMEX's perpetual futures: as the name suggests, these futures have no "delivery" date and are perpetual. You don't need to hold the underlying asset; you just need to trade back and forth. Why do traders use perpetual contracts? Two reasons:

1. Perpetual contract fees are lower compared to spot trading;

2. Perpetual contracts offer higher leverage.

Most traders prefer the simplicity of perpetual contracts. In contrast, options trading requires an understanding of multiple variables simultaneously: strike price selection, underlying asset price, time decay, implied volatility, and Delta hedging. Most cryptocurrency traders transition directly from spot trading to perpetual contracts, completely bypassing the learning curve of options.

In 2016, BitMEX introduced perpetual contracts, instantly becoming the favorite leverage tool for cryptocurrency traders. That same year, a small team from the Netherlands launched Deribit, the first exchange platform focused on cryptocurrency options trading. At the time, with Bitcoin priced below $1,000, most traders considered options too complex and unnecessary. Twelve months later, the tide turned: Bitcoin surged to $20,000, and miners holding large inventories began buying put options to lock in profits. In 2019, Ethereum options went live; by January 2020, open interest in options contracts broke $1 billion for the first time.

Today, Deribit processes over 85% of cryptocurrency options trading volume, indicating that the market is still quite concentrated. When institutions need to execute large trades, they do not choose the order book but instead reach out to an RFQ (Request for Quote) service desk or communicate on Telegram, then settle through the Deribit interface. One-fourth of Deribit's trading volume comes from this private channel, highlighting institutional dominance in this seemingly retail-driven market.

Deribit's unique feature is its allowance of cross-market collateral. For example, you are long on futures (Bitcoin at $100,000) while simultaneously buying $95,000 in put options. If the Bitcoin price drops, the futures long position will incur losses, but the appreciation of the put options can prevent liquidation. Of course, there are many variables at play here, such as option expiry or futures leverage, but Deribit's cross-market collateral feature is a key reason for its dominance.

In theory, on-chain options can easily achieve this: smart contracts can track the strike price and expiry date, hold collateral, and settle profits without the need for intermediaries. However, after five years of experimentation, decentralized options exchanges still account for less than 1% of the options market volume, while decentralized perpetual swap exchanges represent around 10% of the futures market volume.

To understand the reasons, we need to review the three development stages of on-chain options.

The Stone Age of Options

In March 2020, Opyn ushered in the democratization of option issuance: locking ETH as collateral, choosing the strike price and expiry date, the smart contract would mint an ERC20 token representing the right. These tokens could be traded on any ERC20-supporting platform: Uniswap, SushiSwap, or even via direct wallet transfers.

Each option was a separate tradable token: a $1000 call option in July was one token, and a $1200 call option was another, leading to fragmented user experience but a functioning market. At expiry, "in-the-money" option holders could exercise and receive profits, with the contract returning the remaining collateral to the seller. More cumbersome was the fact that sellers had to lock up the full notional value: selling a $1000 call option required staking 10 ETH until expiry to earn a premium of 0.5 ETH.

This system worked well until DeFi Summer arrived. With gas fees skyrocketing to $50-200 per transaction, the cost of issuing an option often exceeded the premium itself, leading to the collapse of the entire model almost overnight.

Developers turned to a Uniswap-like liquidity pool model. Hegic led this transformation, allowing anyone from retail to whale to deposit ETH into a common treasury. Liquidity Providers (LPs) pooled collateral into a single pool, and the smart contract would provide quotes for option trades. Hegic's interface allowed users to choose the strike price and expiry date.

If a trader wanted to buy a 1 ETH call option for next week, an automated market maker (AMM) would price it using the Black-Scholes model and fetch ETH volatility data from an external oracle. After the trader clicked "buy," the contract would draw 1 ETH from the pool as collateral, mint an NFT representing the strike price and expiry date, and send it directly to the buyer's wallet. The buyer could then resell the NFT on OpenSea at any time or wait until expiry.

For users, this is almost like magic: a transaction is completed with no counterparty, the premium flows to LPs (minus protocol fees). Traders enjoy a one-click experience, while LPs enjoy yields; the treasury can issue multiple options with different strike prices/expiry dates simultaneously, without active management.

This magic lasted until September 2020. Ethereum went through a severe crash, and Hegic's simple pricing rule led to put options being sold too cheaply. Put option holders exercised their options, forcing the treasury to pay out much more ETH than anticipated. In just one week, a year's worth of premium earnings evaporated. LPs learned a painful lesson: issuing options in a calm market may seem easy, but without proper risk management, a storm can wipe out everything.

AMMs must lock collateral to underwrite options

Lyra (now renamed Derive) attempted to solve this issue by combining liquidity pools and automated risk management: after each trade, Lyra calculates the pool's net delta exposure (the sum of the delta of options at all strike prices and expiry dates). If the treasury has a net short exposure of 40 ETH, it means that for every $1 increase in the ETH price, the treasury loses $40. Lyra will establish a 40 ETH long position on Synthetix perpetual contracts to hedge directional risk.

AMMs use the Black-Scholes model for pricing, delegating expensive on-chain computations to off-chain oracles to control gas fees. Compared to an unhedged strategy, this delta hedging reduces treasury losses by half. Despite its elegant design, this system relies on Synthetix's liquidity.

When Terra Luna's crash triggered panic, traders fled the Synthetix staking pool, causing liquidity to dry up, resulting in a soaring cost of hedging for Lyra and a significant spread widening. Complex hedging requires deep liquidity sources, which DeFi still struggles to reliably provide.

Searching for Kindling

Decentralized Options Vaults (DOVs) underwrite order flow through auctions, Source: Treehouse Research

In early 2021, Decentralized Options Vaults (DOVs) emerged. Ribbon Finance pioneered this model with a simple strategy: users deposit ETH into the vault, and every Friday, it auctions off cash-secured call options through an off-chain process. Market makers bid on the order flow, with the premium returned to depositors as earnings. Settlement of options occurs every Thursday, collateral is unlocked, and the entire process resets.

During the 2021 bull market, the Implied Volatility (IV) remained above 90%, with weekly option premiums translating into astounding Annual Percentage Yields (APYs). Weekly auctions continued to generate significant returns, and depositors enjoyed seemingly risk-free ETH gains. However, when the market peaked in November and ETH began to decline, the treasury started experiencing negative returns, as the option premiums were insufficient to cover ETH's price drop.

Competitors Dopex and ThetaNuts replicated this model and added rebate tokens to mitigate the impact during loss periods, but still couldn't address the core vulnerability of dealing with significant volatility. In the AMM and DOV models, funds had to be locked until the expiration date. Users who deposited ETH to earn premiums found themselves in a dilemma when ETH price fell, unable to close their positions when needed.

Order Book

The Solana ecosystem team learned from the limitations of early options protocols and took a radically different approach. They attempted to replicate Deribit's Central Limit Order Book (CLOB) model on-chain, implementing a sophisticated order matching engine to achieve near-instant settlement and introducing market makers as the counterparties to every option trade.

The first-generation products like PsyOptions tried to have the order book entirely on-chain, with each quote occupying block space, and market makers having to lock up 100% collateral, leading to sparse quoting. Second-generation products like Drift and Zeta Markets moved the order book off-chain for matching and on-chain settlement. The Ribbon team returned to the battlefield with Aevo, placing the order book and matching engine on the high-performance Optimism Layer2.

More importantly, these products support perpetual contracts and options on the same platform, equipped with a portfolio margin system that can calculate the market maker's net exposure. This is similar to Deribit's key success factor, allowing market makers to reuse collateral.

The results are mixed. As market makers can update quotes frequently without paying high Gas fees, the spreads narrow. However, the weaknesses of the CLOB model are evident during non-trading hours: when U.S.-based professional market makers go offline, liquidity evaporates, and retail traders face large spreads and poor execution prices. This reliance on active market makers leads to temporary "dead zones," a situation that has never occurred in the AMM, despite its flaws. Teams like Drift completely shifted to perpetual contracts, abandoning options.

Teams like Premia are exploring the AMM-CLOB hybrid model, seeking a middle ground between a fully on-chain order book providing 24/7 liquidity and market makers that can deepen the pool. However, the Total Value Locked (TVL) has never exceeded $10 million, and large trades still require market maker intervention, resulting in high slippage.

The Uphill Battle of Options

Option liquidity is shifting from AMM to order book. Derive has deprecated on-chain AMM, rebuilt the exchange around an order book, and equipped it with a cross-margin risk engine. This upgrade has attracted players like Galaxy and GSR, with the platform now handling about 60% of on-chain options trading volume, making it the largest decentralized options exchange in DeFi.

Vlad on Limit Order Book Design

When a market maker sells a $120,000 BTC call option and hedges with spot BTC, the system identifies these offsetting positions and calculates margin requirements based on net portfolio risk rather than individual position requirements. The engine continuously assesses each position: underwriting a $120,000 call option expiring in January 2026, shorting next week's weekly futures contract, buying spot BTC, and requiring traders to post margin based on net directional exposure.

Hedging can offset risk, releasing collateral to redeploy into the next quote.

On-chain protocols tokenized each strike price and expiry date into their ERC-20 token vaults, breaking this cycle. A $120,000 call option minted this Friday cannot recognize the hedge of a BTC perpetual contract. While Derive has partially addressed this issue by adding perpetuals within its clearinghouse to achieve cross-margining, the spread remains much higher compared to Deribit; the spread for equivalent positions is typically 2-5 times higher.

Note: Let's explain using mango prices. Say I sell someone the right to buy mangos at $10, collecting a $1 premium. These mangos ripen in three days. As long as I have mangos (the underlying asset), I can collect the premium ($1) without worrying about a rise in mango market price.

I won't incur a loss (thus achieving a hedge) unless the rise in mango price brings opportunity cost. If Sumanth buys this option (paying me $1), he can turn around and sell mangos at $15, netting $4 after deducting the premium. These three days are the option's expiration date. At the end of the trade, I either still hold the mangos or have received a total of $11 ($10 in mango money + $1 premium).

On a centralized exchange, my mango farm and market are in the same town, and they know the collateral I trade, so I can use Sumanth's payment as collateral to offset other expenses (like labor costs). But in an on-chain market, the two markets are theoretically in different locations and don't trust each other. Due to most markets relying on credit and trust, the capital efficiency of this model is very low—I might end up losing money just by transferring Sumanth's payment to a logistics provider.

Deribit benefits from years of API development and systems optimized by numerous algorithmic trading platforms for its platform. Deribit's risk engine has only been live for just over a year, lacking the deep order books needed in spot and perpetual contract markets for effective hedging. Market makers need instant access to deep liquidity across multiple instruments to manage risk, holding options positions simultaneously and hedging seamlessly through perpetual contracts.

Decentralized perpetual contract exchanges have solved the liquidity challenge by completely eliminating fragmentation. All perpetual contracts for the same asset are identical: one deep pool, one funding rate, where liquidity is uniform regardless of whether a trader chooses 2x or 100x leverage. Leverage only affects margin requirements, not market structure.

This design has enabled platforms like Hyperliquid to achieve significant success: its treasury often acts as counterpart to retail trades, redistributing trading fees to treasury depositors.

In contrast, options disperse liquidity across thousands of "micro-assets": each strike-expiry combination forms an independent market with unique characteristics, leading to capital fragmentation and making it nearly impossible to achieve the depth needed by sophisticated traders. This is precisely the core reason why on-chain options have failed to take off. However, given the emergent liquidity on Hyperliquid, this situation may soon change.

The Future of Cryptocurrency Options

Looking back at the launch of all major options protocols over the past three years, a clear pattern emerges: Capital efficiency determines survival. Protocols that force traders to lock separate collateral for each position, no matter how complex their pricing models or how sleek their interfaces, ultimately lose liquidity.

The profit margins for professional market makers are razor-thin; they need every cent to work efficiently across multiple positions. If a protocol requires them to deposit $100,000 collateral for a single Bitcoin call option and another $100,000 for hedging perpetual contracts instead of considering this collateral as offsetting risk (possibly requiring only $20,000 net margin), then participation in the market is unprofitable. Simply put: no one wants to lock up a large amount of capital to earn just a little.

Source: TheBlock

The spot market daily trading volume on platforms like Uniswap often exceeds $1 billion with minimal slippage; decentralized exchanges for perpetual contracts like Hyperliquid process hundreds of millions of dollars in daily trading volume with competitive spreads comparable to centralized exchanges. The much-needed liquidity foundation for options protocols now exists.

The bottleneck has always been the infrastructure: the "pipes" that professional traders take for granted. Market makers require deep liquidity pools, real-time hedging capabilities, instant settlement in times of position deterioration, and a unified margin system that treats the entire portfolio as a single risk exposure.

We have previously discussed the shared infrastructure approach of Hyperliquid, which has created a positive-sum status rarely realized in DeFi: each new application strengthens the entire ecosystem instead of competing for scarce liquidity.

We believe that options will ultimately take an "infrastructure-first" approach to go on-chain. Early attempts focused on mathematical complexity or clever tokenomics, while HyperEVM addresses the core "pipe" problem: unified collateral management, atomic-level execution, deep liquidity, and instant settlement.

We see several key aspects of market dynamics changing:

· After the 2022 FTX collapse, market makers participating in new primitives and assuming risk have decreased; now, traditional institutional participants are re-entering the cryptocurrency market.

· There are more battle-tested networks able to meet higher transaction throughput demands.

· The market is more accepting of certain logic and liquidity not entirely on-chain.

If options are to make a comeback, it may require three types of people: developers who understand how the product operates, experts familiar with market maker incentives, and individuals capable of packaging these tools into retail-friendly products. Can on-chain options platforms allow some to earn life-changing wealth? After all, Memecoins have achieved this—they have made the dream of turning a few hundred dollars into millions a reality. The high volatility of Memecoins makes this work, but they lack the "Lindy Effect" (the longer it exists, the more stable it becomes).

In contrast, options have both the Lindy Effect and volatility, but are difficult for the average person to understand. We believe there will be a category of consumer-grade applications focused on bridging this gap.

Today's cryptocurrency options market is akin to the state before the establishment of the Chicago Board Options Exchange (CBOE): a pile of experiments, lacking standardization, primarily speculative rather than hedging. However, as the cryptocurrency infrastructure gradually matures, transitions into true commercial operation, this situation will change. Institutional-grade liquidity will move to the chain through reliable infrastructure, supporting cross-margin systems and composable hedging mechanisms.

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