How Hegic creates Options Contracts & Sourcing Liquidity In A Decentralized Manner Explained 2022

6 min read

How Hegic creates Options Contracts & Sourcing Liquidity In A Decentralized Manner Explained 2022
EXECUTIVE SUMMARY
  • Decentralised Finance (DeFi) has so far covered several key activities, including exchanging with Uniswap, earning with Aave, yearn.finance, and MakerDAO, holding with Lido, and trading perpetual contracts with dYdX.
  • Hegic will teach us how to trade decentralised options contracts this week. 
  • How does Hegic work? Hegic is an Ethereum-based peer-to-peer options trading protocol. 

Market Recap

Source: Glassnodes and Coin Metrics

Digital Assets Fall While Traditional Markets Rise

Source: Tradingview

Options Trading With Hegic

Our journey into Decentralised Finance (DeFi) has so far covered several essential activities one can participate in, including exchanging with Uniswap, earning with Aave, yearn.finance and MakerDAO, staking with Lido and trading perpetual contracts with dYdX. Our journey continues this week as we learn how to trade decentralised options contracts with Hegic. 

What is Hegic?

Hegic is an onchain peer to peer options trading protocol built on Ethereum. 

Options are more complex than many other traditional financial instruments, and you should thoroughly understand how they work before using them. There are a few different onchain option protocols to choose from; however, this sector is still small due to the nuances around creating onchain option products and the demand for them. 

This week we decided to focus on Hegic. A simple platform for trading Ethereum (ETH) and Wrapped Bitcoin (WBTC) options. 

Hegic was launched in April 2020 by Molly Wintermute, an anonymous developer and, unfortunately, had a rough start straight away – around $30 000 worth of user funds got locked in a smart contract due to a bug. This issue set Hegic back; however, they have learned from their mistakes and have continued building the protocol over time. Since launch, they have been on the Ethereum mainnet and have now released a new Beta version on Arbitrium, an Ethereum layer 2. 

Creating option contracts and sourcing liquidity is particularly difficult in a decentralised manner, so how have Hegic managed to do it?

How Does Hegic Work?

Hegic has created a way for people to take out option contracts in a decentralised manner. However, why would someone need to take out an option contract in the first place? To understand this, we need to understand what an option is.

What is an Option?

People use options to speculate on the market as they allow you to profit when they go up and down, and they are also used to hedge a position to limit the risk of it moving one way. An option is a contract that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a specified price on or before a specific date. The buyer pays a premium to the option seller to enter into this agreement.

It is always recommended that you do your own research and completely understand what an option contract is before entering into one, as they can be complicated and do carry a degree of risk. 

Below is a helpful video to understand what an option is and how it works://www.youtube-nocookie.com/embed/GzkKFRx1Dhk?rel=0&autoplay=0&showinfo=0&enablejsapi=0

Here are some of the key terms one should also understand before you begin trading:

Option: Options are financial instruments that are derivatives based on the value of underlying assets such as ETH or BTC. An options contract offers the buyer the opportunity to buy (calls) or sell (puts) the underlying asset.

European Settlement: An options contract that can only be exercised at expiration. Exercising a call or put option will only take place on the date of the option’s expiration.

American Settlement: An options contract that allows holders to exercise the option at any time before, and including, the day of expiration.

Physical Settlement: Physically settled options are options contracts whereby settlement requires the actual physical delivery of the underlying asset. For example, a put option holder will “put” ETH to the options seller at the option’s strike price, even if ETH is worth 0.

Cash Settlement: A cash-settled option is a type of option whereby settlement results in a cash payment, instead of settling in the underlying asset. The cash payment is equal to the option’s intrinsic value at the time it’s exercised.

Call Option: A call option is a financial contract that gives the option buyer the right, but not the obligation, to buy an asset at a specified price for a specific amount of time.

Put Option: A put option is a financial contract that gives the option buyer the right, but not the obligation, to sell an asset at a specified price for a specific amount of time.

Option Buyer: The person who buys an option by paying a premium. This person has the right, but not the obligation, to exercise the option. Also known as an options “holder,” or someone who is “long” an option.

Option Seller: The person who sells an option in return for a premium. The option seller is obligated to perform when the buyer exercises their right under the option contract.

Collateral: Collateral refers to an asset given as security by the options seller in order to hedge the credit risk of the options transaction.

Underlying: The underlying asset on which an option’s value is based. It is the primary component of how an option gets its value. Options are classed as derivatives because they derive their value from the performance or price action of an underlying asset.

Premium: The money paid upfront by the option buyers to the option sellers in return. It is the cost of the option.

Bid: The price a buyer is willing to pay for the option. If you’re selling an option, this is the premium you’d receive for the contract.

Ask: The price a seller is willing to accept for the option. If you want to buy an option, this is the premium you’d pay.

Strike Price: A strike price is the set price at which an options contract can be bought or sold when it is exercised. For call options, the strike price is the price an asset can be bought; for put options, the strike price is the price at which the asset can be sold.

Expiration date: The date when the options contract becomes void. For European options, it’s the due date for options buyers to exercise the options contract. For American options, it’s the date by which options buyers must exercise the options contract.

Exercise: To exercise means to put into effect the right to buy or sell the underlying asset at the strike price. If the holder of a put option exercises, they will sell the underlying asset. If the holder of a call option exercises, they will buy the underlying asset.

At The Money (ATM): A call or put option is at-the-money when its strike price is the same as the current underlying asset price.

In The Money (ITM): Refers to an option that possesses intrinsic value. A call contract is in the money when its strike price is less than the current underlying asset price. A put contract is in the money when its strike price is greater than the current underlying asset price.

Out of The Money (OTM): An option that only contains extrinsic value. A call option is out of the money when its strike price is greater than the current underlying asset price. A put option is out of the-money when its strike price is less than the current underlying asset price

Time value: The value of an option based on the amount of time before the contract expires

Intrinsic value: The in the money portion (if any) of a call or put contract’s current market price. Intrinsic value is a measure of what an option is worth

Volume: The number of contracts traded that day

Open interest: The number of options contracts currently in play.

Wade Prospere – Opyn

While these terms can be confusing, understanding them is crucial. Therefore take your time. 

Hegic offers American, cash-settled call and put options with a fixed premium. 

How To Use Hegic

Hegic is available on both the Ethereum mainnet and the Arbitirum layer 2 rollup. 

For the purpose of this guide, we are going to use Hegic on the Ethereum mainnet and in order to do this, you will be required to set up and fund a MetaMask wallet. Alternatively, if you want to move funds on to Arbitrum and use Hegic, you can follow our guide here.

Take Out An Options Contract On Hegic

Step 1: Set Up MetaMask Wallet

In order to interact with Ethereum, you require a wallet. Our wallet of choice is MetaMask, but you are free to choose your own. Please find our guide to setting up your own MetaMask wallet here. 

Once you have set up and funded the wallet, you can now use Hegic.

Step 2: Visit the Hegic Website

  • Visit the Hegic Website
  • Make sure you land on https://hegic.co/
  • Click Launch Hegic in the top right hand of the screen
  • You will be prompted to connect your wallet
  • We want to use the Ethereum mainnet and the MetaMask wallet
  • Select both
  • Enter your MetaMask password when prompted

You should see the below page:

Step 3: Review Options Contract Terms

Now your understanding of options and the terminology becomes essential. Hegic has done an excellent job at simplifying it and making it a bit easier to understand. There are four different inputs:

1) Option Type – Call or Put

2) Option Currency – ETH or WBTC

3) Size – See Available Limit

4) Period – 1 to 45 Days

  • Determine what is most appropriate for your risk profile and enter the details
  • Hegic also have a handy sliding scale that you can use to determine your profit at different prices 
  • You will also see the cost of the premium you will have to pay to take out the option contract

  • Once you are happy with the put or call option you are about to purchase, you can go to the next step

Step 4: Approve Hegic Options Trading Contract

  • As a security measure, you will have to approve the Hegic smart contract if it is the first time you are using it 
  • Click Approve
  • Be patient while the transaction is completed. It may take some time
  • Once this has gone through, confirm the details of your contract
  • Click Confirm Now
  • Whenever prompted, click “Confirm” to sign the transaction on MetaMask if you are happy with the gas fees

The transaction may take some time, so be patient. However, once it has gone through, you have now taken out a call or put option. You can monitor the option contract in the My Positions tab. 

Hegic also has other offerings you can explore, including adding liquidity and making markets (you will essentially be selling put or call options) or staking the Hegic token to earn staking rewards. 

Conclusion

Using these networks is the best way to learn about them. It shows and allows you to understand what blockchain networks are capable of. Each has its own unique advantages, disadvantages and user experiences. 

Projects like Hegic, although still a straightforward offering compared to traditional alternatives, show what blockchains are capable of. These projects provide a glimpse of the possibilities of a financial system delivered on a blockchain, a more efficient rail where more people can participate.

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