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HEGIC PROTOCOL: Bringing option trading to the DeFi space

Thu Nov 19 2020
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A new protocol has taken the DeFi space by storm: HEGIC. Coded over a period of a couple of months in a city library by an anonymous developer called Molly Wintermut, HEGIC is currently growing at lightspeed with over $50m being locked in the protocol and a market cap of $85m.

What makes Hegic special?

In its current form, Hegic is a non-custodial options trading platform allowing users to buy put & call options on ETH and WBTC. Unlike centralized option trading platforms, Hegic is completely non-custodial, KYC less, composable (meaning it integrates with the rest of DeFi) and lets liquidity providers participate in the economic success of the platform.

Hegic_LP.png

Before we go through each of these characteristics and the in’s and out’s of the platform in detail, we’ll do a short introduction on options.

What are Options?

Options are financial instruments that allow the holder to buy or sell an asset at a specified price. They are derivatives since they derive their price from an underlying asset. The terms of the option are set by the options contract.

  1. CALL options: allow the holder to buy the asset at a determined price within a specific timeframe.

  2. PUT options: allow the holder to sell the asset at a determined price within a specific timeframe.

Each option contract has a specific expiration date by which the holder must exercise the option. The price for which the option holder can buy (or sell in the case of a PUT option) the asset is known as the strike price. The fee that the option holder has to pay for having the right to buy (or sell) at the specified price is known as the premium.

Why are Options popular?

Let’s begin by making clear that the global option markets are gigantic. Option contracts can exist for any financial asset whether it’s stocks, commodities or real estate and their volumes often exceed the underlying spot market volume (where buyers & sellers trade assets at face value) by multiples.

There are many reasons why options are so popular with traders. Let’s go over a few.

Higher Potential Returns

The returns that can be achieved with options are uncapped. Consider a CALL option on Ether with a strike price of $500. If ETH goes up to $10.000 within the timeframe specified in the option contract, your return will be $9500 (minus the premium).

Capital Efficient

Options allow traders to get the same level of exposure to the price movement of an asset than if they would trade on the spot market, while putting up much less capital.

For example, the ETH CALL option in the example above might cost $200, much less than if you would buy 1ETH at $500 on the spot market.

Less Risky

There are a couple of reasons why options are less risky than other instruments chosen by traders to get exposure to the price of an asset. For one, your downside is capped. Using our example one more time, the most you can lose is the $200 premium you paid for the right to exercise the option. If the price of ETH goes to $10 you would simply let the option expire without exercising it, while if you had bought 1ETH at $500 on the spot market you would have lost $490.

Compared to margin trading, which lets traders finance a large purchase by leveraging their capital, there is also no liquidation risk. It’s a fact that crypto markets can be volatile and whereas a margin loan can be instantly liquidated if there is a sudden downswing, options are only temporarily affected by price swings. If the asset price recovers after the downswing, the option can still be exercised at a profit.

Hedging

Options are also an efficient and relatively inexpensive tool to hedge your positions. In simple terms, hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. For example, if you are LONG on bitcoin, you can buy a PUT option that allows you to sell bitcoin at a favourable price if bitcoin were to crash. This PUT option would thus “insure” your overall portfolio from a crash in the bitcoin price.

How to buy an option on Hegic?

Buying an option on Hegic is incredibly fast and seamless. Needless to say that like every application on Ethereum, no KYC is needed and your Ethereum wallet can be connected in one simple click.

HEGIC_CALL_OPTION.png

Next, you choose the asset you want the option contract for and the type of option. PUT options allow you to sell your asset at a specified price and CALL options allow you to buy the asset at a specified price. Usually, PUT options are for shorting an asset and CALL options are for long exposure.

You can then set the strike price, which determines the price at which the option becomes exercisable and define the duration of the option contract. You can play around with the inputs and see how they influence the premium or “Total Cost” you have to pay for the option contract.

WBTC_OPTION.png

Once you bought the option you will automatically see it appear in the hegic.co dashboard. In our case for instance, we bought a CALL option to buy 0.5 WBTC at a price of $15000 with an expiry date in 31 days (18 at the time of writing). Since the price of bitcoin moved upwards since the purchase, our option is currently in the money (ITM). If we would exercise it today, we would exit with a profit of $558.

The profit can simply be calculated by subtracting the strike price and premium from the current asset price, in our case:

Profit = 0.5 *(17916-15000) - premium

Note, that the option break-even price can fluctuate as the premium which you pay at the beginning when you buy the option is priced in ETH. Thus, if the price of ETH goes up or down it will affect the dollar value of your premium and therefore ultimately your profit.

If your option is in-the-money (ITM) at any time during the option's duration, you can manually exercise the option but you have to do it before the option expires else you won’t receive the payout.

If you prefer a video tutorial to guide you through this process, watch DeFi Dad’s tutorial on “How to Buy options on Hegic”.

Providing Liquidity on HEGIC

One of the breakthroughs of DeFi is that it removes middlemen and allows users to participate in the important operations of the protocol. As such, users can provide liquidity to the option pools to collateralize the protocol. Options need to be collateralized by the platform since they represent an obligation to pay the user in case the option becomes exercisable. Centralized option trading platforms would do this in-house as it is a source of revenue but in Hegic this task is outsourced to the community. The more liquidity is provided, the more usable the protocol becomes as option holders can take larger positions at a better price.

The rationale for supplying liquidity is that, if, the premiums paid by option holders are higher than the payouts to options holders, the liquidity providers will accrue profits proportionate to their share of the pool. Moreover, liquidity providers receive $HEGIC rewards for contributing to the protocol and taking on risk.

HEGIC_LP_PROVIDER.png

In our case, we contributed 35ETH to the ETH option liquidity pool. At the time of writing, we have a slightly positive P&L and we have also accrued over 10.000 $rHEGIC tokens (more on those later).

Effectively, when you provide liquidity to either the ETH or WBTC option pool you are short on volatility in the respective market. What this means is that if price movements are not too significant, liquidity providers have little risk exposure.

In normal market conditions, PUTS and CALLS cancel each other out, meaning that if PUTS are in the money CALLS expire out of the money and vice versa. However, in the crypto market the option pool is often skewed towards CALL options, as most people are bullish on crypto prices. In the case of a sudden bull run, this is a risk you need to be aware of and take measures against, should you decide to become a liquidity provider.

HEGIC tokenomics

$HEGIC is the future governance token of the Hegic protocol. More importantly, at present HEGIC is needed to buy a staking lot. Each staking lot requires 888.000 HEGIC tokens (currently $222.000). In return, staking lots receive 100% of the settlement fees in ETH and WBTC generated by the protocol.

Since this is a lot of money for most ordinary people, developers in the community are already busy developing HEGIC staking pools that let users participate in a staking lot with any amount.

Two Hegic staking projects already live are zlot.finance and hegicstaking.co and a third is currently being developed by yearn.finance.

The case for the HEGIC token is the following: the more option volume is turned over on the platform, the more settlement fees will be earned and the more interesting it will become to acquire enough HEGIC tokens for a staking lot.

In total, there are 3,012,009,888 HEGIC. By far the largest chunk of the supply, namely 40%, is reserved for liquidity mining until 2023. 80% of these rewards for Hegic protocol users go to liquidity providers and 20% go to option holders since both perform crucial tasks for the development of the protocol. The remainder of the supply is split across the Hegic Development Fund (core team), Early Contributors (third party developers building integrations & community tools), liquidity provision for the HEGIC token on decentralized exchanges and finally 3% was sold on the IBCO (read more here).

Hegic Rewards for Liquidity Providers

When you provide liquidity to the option pools you receive a token called writeETH as proof for your deposit in the option liquidity pool. This token must be staked to receive $rHEGIC. In our case we provided 35ETH and received 11,200 $rHEGIC over a period of two weeks.

Now what is $rHEGIC you may ask. In short, $rHEGIC is an IOU. It will be exchangeable 1:1 against $HEGIC in the future but not now as the HEGIC core team wants to foster long-term alignment with the protocol. For $rHEGIC tokens to be exchangeable one of the following milestones needs to be reached: on-chain trading volume > $100M or on the 11/11/2021. Until then $rHEGIC can not be used for much. However, since it represents a claim on $HEGIC in the future it can be sold on Uniswap (albeit at a discount).

rHEGIC.png

Hegic Rewards for Option Holders

Users who purchase options on Hegic, receive utilization rewards (20% of total rewards) for holding options and using the Protocol. The exact amount you receive depends on the value and the duration of your options. Since they are distributed proportionally, it also depends on how much other option holders exist at the time of your purchase.

Conclusion

All in all, HEGIC is one of the most interesting protocols in DeFi at the moment. Options are the missing piece in the array of financial primitives that are being replicated from the traditional finance world. Moreover, although HEGIC is only a couple of months old, it already has a vibrant community of developers contributing to the development of the protocol.

It will be interesting to watch if Hegic can attract more liquidity in the option pools. This liquidity is needed to cut the fees option holders have to pay for their options, which are currently not competitive with centralized option platforms. However, already today the platform offers advantages that centralized competitors will never be able to offer. No KYC, distributed ownership but most importantly composability. We can see the first effects of composability with Andre building on the Hegic stack to offer options on any ERC-20 token, not just ETH or WBTC.

Equally important, is the development of a secondary market for tokenized Hegic PUT and CALL options. Currently on HEGIC options can only be exercised when they are in-the-money. In other words it is worthless, as long as your option has not passed the break-even price. In traditional markets, an option also has value on the secondary market when it is out-of-the-money but volatility is high.

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Emanuel Coen

I am passionate about Bitcoin and Ethereum and want to on-board new people to crypto.

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