Looking under the hood of Rysk’s Dynamic Hedging Vault
Rysk’s Dynamic (Delta) Hedging Vault aims to provide investors/liquidity providers with market uncorrelated yields. “What does that mean?” I hear you ask — well, let’s take a look at something that caught our eye:
If you’ve been in the crypto space a little while, you’ve probably noticed that most things tend to move up and down together. Some days are ‘good’ and most cryptocurrencies go up in price, but every now and then the inevitable crash comes and you’ll struggle to find anything that bucks such a strong trend, as we noticed above. To make matters worse, when a market starts turning bearish, people tend to become more risk-averse. This results in them borrowing less and moving into ‘safer’ assets, which tends to cause a general decrease in yields — so even people lending out their stablecoins start feeling the downturn! Our vault aims to offer Bogdanoff-proof yields which are consistent whether the market is mooning or dumping.
So how do we do this? Here we try to explain what delta is and how we use it to achieve this goal:
Options pricing is a whole world of big brain math — it is calculated using the Black-Scholes model and it would be pretty impractical for options traders to have to use it themselves to calculate how their option’s value will change in value based on different factors. Luckily for us, every option has properties that do exactly this for us! These are called The Greeks, since we use Greek letters to represent them: delta (Δ), gamma (Γ), vega (ν) and theta (Θ) are the most common.
Delta definition:
Delta, Δ, measures the rate of change in the value of an option with respect to a change in the price of the underlying asset.
In simpler terms, if you buy an ETH option that has a price denominated in USD, the option’s delta will tell you how much more/less your option will be worth — according to the Black-Scholes model — if the price of ETH increases by $1 (assuming all other factors remain constant).
For a practical example, on 17th January 2022 around 13:00 UTC, ETH was trading at $3268 and the following option was available on Deribit:
Type: Call
Strike: $3300
Premium: $21.20
Expiry: 18 Jan 2022, 08:00:00
Delta: 0.35
Alice believes that by the expiry date (18th Jan 2022, 08:00:00) the price of ETH will be above $3300, so she buys the call option for $21.20. We can say Alice is in a long call strategy. If the price of ETH immediately rises $1 to $3269, she could expect the value of her option contract to rise $0.35, to $21.55. Note that this assumes all other factors affecting option pricing remain constant.
Why do different options have different Delta values?
First, lets take the above example and chart Alice’s profit/loss on the long call strategy at expiry against the value that ETH trades at on expiry.
You can see that by purchasing a call option, the most she will ever lose is the premium she paid for it ($21.20) if the option expires worthless. As the price of ETH rises above the strike price of $3300, the profitability at expiry increases in a linear fashion. This is one of the reasons why long call strategies are so great — limited downside and unlimited upside!
Before an option expires, we can break its value up into two parts: intrinsic and extrinsic value. An option has intrinsic value because it is In The Money (ITM). In the above example, if ETH is trading at $3350, Alice’s option has $3350–$3300 = $50 of intrinsic value. Extrinsic value is made up of things such as time value until expiry, implied volatility, and the risk-free interest rate. This premium is the amount over the option’s intrinsic value that an investor is willing to pay, and reflects the probability that the option’s value will increase before expiry.
In our example, when Alice paid for her call option, it had no intrinsic value, because ETH was trading below the strike price at which the option becomes profitable. Therefore, the $21.20 she paid was all extrinsic value.
Call options that are deep ITM have a delta value that approaches 1. This is because their value is almost entirely made up of their intrinsic value and there is little risk that the option expires worthless. In our example, if ETH were to be trading at $3500 shortly before expiry, you could expect that a $1 increase in the price of ETH would result in the option being almost $1 more valuable.
On the other hand, if the option is deep Out of The Money (OTM), its value is entirely extrinsic. Looking at our chart, you can see that there is no difference in the option’s value at expiry if ETH expires at $3100 or $3200. As a result, deep OTM options have a delta that approaches 0, since it is unlikely that the option will expire with any value.
At The Money (ATM) call options (where the asset is trading at the strike price) have delta values around 0.5, representing the uncertainty of the option expiring worthless.
Now let’s assume Alice believes that by the expiry date the price of ETH will drop below $3000, so she buys a put option instead. We can say Alice is now in a long put position.
The above principles apply to put options too, but instead of having delta values between 0 and 1, they are between 0 and -1 — representing a decrease in value as the underlying asset appreciates.
- Deep in the money options have Δ approaching 1(calls) or -1(puts).
- At the money options have Δ around 0.5(calls) or -0.5(puts).
- Deep out of the money options have Δ approaching 0.
Remember, this is a general rule and many factors affect the delta of an option, but moneyness plays a large role.
How does Rysk use delta to provide market uncorrelated returns?
Our Dynamic Hedging Vault (DHV) is a self-governing options AMM, meaning it will allow anyone to buy options with a wide range of strike prices and expiry dates. On the other side of this protocol, we need liquidity, and this is where our high IQ, risk-savvy, market-neutral yieldoooors enter; they deposit their capital into the vault, which will, in turn, be used to collateralize those sold options.
Using the same example as above, Alice buys her call option from the Rysk DHV which is, of course, collateralized using funds from liquidity providers. Alice is now long one call option with a delta of 0.35. The vault is short one call option so has its own delta exposure that is the negative of the sold option, -0.35.
The vault now has a negative delta exposure and feeds this value into our option pricing algorithm, which then reprices the options we sell to incentivize people to buy options that move our delta back towards 0. The vault has a delta of -0.35, so it prices options that increase its own delta value more favourably. In a perfect scenario, Bob will come along and buy a put option with a delta of -0.35 from the DHV, raising the vault’s delta exposure by 0.35 and leaving the vault with 0 delta exposure from the two sold options. Having a delta of 0 in this case means that, should the price of ETH rise, the rise in value of Alice’s call option will be perfectly balanced by the decrease in value of Bob’s put option — and vice versa if the price of ETH falls. The vault’s liabilities — the total outstanding value of its short options — remain constant. In reality, the perfect scenario where delta is exactly equal to zero is unlikely and, as the underlying moves over time, the delta of the position moves as well, creating frequent incentives for buyers to trade with DHV.
From this you can see how by skewing the price of options, the vault can not only hedge its delta exposure, but also be paid to do so. Hedging is usually costly, especially on blockchains where every transaction incurs gas costs. Our vault not only offsets those costs to the traders purchasing options from the protocol, but our liquidity providers will be paid the premiums on the purchased options by the traders who hedge for them. Our liquidity providers have a source of yield that has no correlation to the price of any underlying assets. Check this post to learn why low correlation matters.
We expect to use a portion of the DHV revenue to carry out hedging strategies during instances of high demand on one side of the DHV (puts or calls) where option pricing skew alone is not enough to achieve market neutrality. This will be done by trading spot or using DeFi derivatives instruments, such as perps or other options, so keep an eye out for announcements!
Join the rysk community
If you are interested in market neutral returns and derivatives in DeFi you should hang out on our Discord, we talk about DeFi, derivatives, options, and obviously uncorrelatedness!
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Before Rysk you were in crypto and stables; after Rysk you will be in crypto, stables, and Rysk.
