What are Decentralized Option Vaults?
What are DOVs?
Decentralized option vaults (DOV) are a relatively new product in DeFi. DOVs are an automated product executing a predefined option strategy. Users deposit collateral into DOVs which then puts the capital to work to generate yield typically on a weekly basis. Since yield is received not from the token issue, but from the buyers paying premiums, DOVs can be considered a source of “real yield”. But don’t forget that selling volatility (which is almost the same thing as selling options) is a risky business which can result in large losses.
How can DOVs disrupt DeFi?
Most structured products on DOVs are vanilla calls and puts. But eventually more complex option strategies will be developed which will better use the collateral increasing investors’ returns. DOVs change the asset management in DeFi too. Prior to them, structured products were available only to accredited investors. Now retail investors have access to complex trading strategies. By selecting a vault suitable to their risk-return profile they can enjoy return above normal yields.
DOVs will also improve liquidity in derivatives markets in digital assets industry. One can only trade BTC, ETH or SOL options on Deribit, the leading crypto derivatives exchange, while there are AVAX, NEAR or AAVE vaults with non-negligible volume. And the strong derivatives market will likely result in the increased liquidity for the spot market.
Finally, DOVs are changing 2/20 traditional fee structure of the hedge fund industry. Even now, there are DOV protocols, such as Thetanuts, which don’t charge investors since they “found that charging a performance fee simply harms user's yields too much.”
DOV strategies
The most popular DOV products are covered call selling and cash-secured put selling strategies. A covered call is a strategy combining selling a call option with holding the underlying asset. If the asset price trades above the strike price of covered call at the expiry date, the call option will be in-the-money which means that option seller will sell the asset keeping the premium. If the asset price is below the strike price at maturity date, then the option will be worthless. And option seller will keep both his asset and option premium.
Cash-secured put strategy involves selling a put option on an asset and putting aside cash to buy the underlying is the put is exercised by the buyer. For taking this obligation, the option seller gets premium. If the asset price trades below the strike price at the maturity date, the seller will have to buy the underlying with cash put aside keeping the premium he received. If the asset price is above the strike price at the expiration of the option contract, the option will finish worthless. The seller will keep the premium as a yield.
How do DOVs work?
Now that we understand these two strategies, we can look at inner workings of DOVs, equivalents of structured products of legacy markets in DeFi. After DOVs open for users, investors lock up their collateral into the vault they want. The deposit for call selling vaults is typically the underlying token, and that for the put selling vaults is stablecoin. (you remember that in cash-secured put selling you put aside cash, right?)
The next step is selling or writing options to investors participating in auctions at predetermined time. Almost all DOV protocols sell options on a weekly basis as far as I know. This has some advantages the first of which is the volatility of crypto assets. It is difficult to predict the price of a cryptocurrency even in moderately long period. Imagine ETH price is $1,700 now and you sell ETH $1,800 call option. Which duration would you select for the trade: a week or a month? The answer should be obvious. The probability that ETH will hit $1,800 in a week is much lower than in a month. Also, a weekly timeframe lets an investor to compound gains on a more frequent basis. On top of writing options weekly, DOV protocols select strike prices based on backtested results to decrease the risk of options being exercised.
