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How to make money selling options with Ribbon

Fynn

4 months ago ·

14 min read

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Introduction

In this article, I will review Ribbon Finance and explain some of the reasons why I think it’s one of the most exciting projects in DeFi.

​​In the past year, many teams have worked on building the key ingredients necessary for a new financial system from scratch - exchanges, stable coins, oracles, lending platforms, derivatives, and more. With the blooming of a new financial ecosystem came lucrative ways for users to make money. To name a few: price arbitrage between synthetic assets, lending out assets to traders wishing to take leverage, or earning fees by adding liquidity to automated market makers. Many of these strategies still exist but are slowly fading over time or involve circular yields that are not sustainable over the long term. For example, providing liquidity to an incentivized pool to receive (a.k.a “farm”) governance tokens and selling those back for a profit. Early adopters were able to earn outsized returns by using their capital as described but as more users start taking advantage of the same opportunities yields are diminishing over time.

How to produce long-term high yield sources and in the spirit of Defi, make them accessible to retail users?

Enter a new set of sustainable yield protocols. New investment strategies that bridge the worlds of TradFi and DeFi. Use cases include the tokenization of real-world assets (RWA’s) like account receivables, consumer loans in developing countries, non-collateralized loans or packaging complex trading strategies into structured products. These are the future of DeFi.

Introducing Ribbon Finance

Let's begin with a small introduction of structured products. Structured products were first introduced to investors in the 90’s to enable easy and low-risk access to equities. Today, these commonly involve packaging multiple investment strategies using a variety of assets into a single product. What’s been very popular in TradFi (Structured products market size) has recently made its way to DeFi with Ribbon.

In an effort to make options trading accessible to anyone, Ribbon has created a set of automated option selling strategies in which retail users can engage in and if successful earn yields on a weekly basis. Ribbon currently offers 4 different trading strategies for users to choose from represented by so-called Theta Vaults. Each theta vault earns yields between ~19% to ~35% annually from the premiums it earns on writing weekly call or put options. Ribbon has attracted over $100m in user funds and earned users over $4m in yield since april.

Before we tell you about Ribbons theta vaults, we first want you to understand how options work to explain their source of yields.


Watch our interview with Ribbon co-founder Julian Koh

Understanding how Ribbon earns money - Options 101

An option is a financial contract that gives the buyer of the contract the right but not the obligation to purchase or sell an asset at a predetermined price. Unlike purchasing an asset at the spot, options contracts allow investors to bet on the price of an asset with a fixed downside and a high potential upside (especially for volatile assets) without actually buying the asset. Investors buy CALL options to bet on the price increase of an asset and PUT options to be on the downside. To understand how options work, you need to understand the 3 main components of an option. You buy an option contract for a premium, that gives the holder the right to buy or sell an asset at a set strike price until the contract’s expiry date.

The strike price of an option is the predetermined price at which you have the right to purchase an asset at. The expiry date is the length of your options contract. This establishes a timeframe until what date you have the right to purchase the asset at the strike price. The premium is the price you pay for an option.

What is a call option and how does it work?

Let's run through an example of a call option. As an investor, I bet that the price of an Amazon share ($AMZN) is going to increase from $50 to $100. I can bet on this by buying a call option with the following components. Strike price = $60, expiry date next week and costs me $5 (premium = cost to buy option). Depending on if my prediction is correct, I have now paid $5 which allows me to purchase $AMZN at $60 a week from now. At the current price of $50, my option is worth nothing. However, as shown in the graph below, my option to buy a share at $60 becomes more valuable once the price of $AMZN increases. I break even ( I'm “in the money”), once $AMZN goes above $65 which is the options premium ($5) + the strike price ($60). From here on out as the price keeps going up, my upside increases as I can buy a share of $AMZN at a discount.

  • So why not just buy a share of $AMZN for $50? What if the price goes down to $10 by next week? By buying an option I have a cheap way to gain exposure on increasing prices and minimize losses on the downside. As opposed to paying 50$ at the time to buy 1 share and losing $40, with the call option my maximum downside is the premium I pay ($5).
  • What's the difference between a call option and a covered call option

call option.png

What is a put option and how does it work?

Put options work the same way as to call options however they are used to bet against the price of something. Here again, we have the same components as before: Strike price, expiry date, and premium. However, instead of the option to BUY an asset at the strike price, you now have the option to SELL someone else's asset at the strike price. Puts give owners the right to sell a share at a specified "strike price" before certain expiration dates. If the companies' stock prices fall below the relevant strike prices before the options expire, the owner can sell the shares for a profit. In this example, I want to bet the price of Bitcoin will go down from $40’000 to $35’000 1 week from now, so I buy a put option with a strike price of $39’000, with an expiry 1 week from now at a premium (price of the option) = $100.

  • Scenario A: Bitcoin is at any price above $39’000 by next week. My option is worth $0 at expiry and I’ve lost $100. Nobody values my right to sell BTC below the current price.
  • Scenario B: The Bitcoin price goes down to $35’000 as expected and my option to sell bitcoin at 39’00 starts to gain in value. At this price I can exercise your right to sell bitcoin at 39’000, leaving me with $3900 profit (39’000-(35’000+$100)).

Put option.png

How does Ribbon finance use options contracts in their vaults?

What we explained above was the perspective of somebody buying call and put options. Ribbon finance takes the other side of this trade and utilizes user funds to sell (aka. underwrite) call and put options that they sell to other participants in the market with the hope of earning money from the options premium.

An option seller makes money from the premium paid on an option when the option stays “out of the money” (OTM). A call option is OTM if the price is below the strike price at expiry. A put option is OTM when the price is above the strike price at expiry. With the fund's users deposit in Theta vaults, ribbon writes options on a weekly basis using Opyn with a carefully calculated strike price that aims to maximize the sale price of the option while minimizing the risk of the option being “in the money”. Each time they do so, the premium earned by the vaults is returned to the investors of the vault, compounded, and reinvested the following week.

Why is this useful?

Although it's possible to create and write (sell) option contracts by yourself, there are many variables involved in the process that make them difficult for the regular investor. Apart from the cost of creating these contracts, you also need to set the correct strike price and expiry date to balance the risk/reward of the price you can sell an option at vs the likeliness of your option being exercised (being “in the money”). This requires a deep understanding of an asset's implied volatility, option pricing, and a series of complex greek letters.

Deribit.png User interface of a regular options platform, giving an example of the complexity behind trading & selling options

Ribbon UI.png Ribbon interface showing 3 of 4 possible Theta vaults

Vault UI.png Deposit interface for the USDC put selling strategy

Products

Eth covered call.png Vault 1: T-ETH-C

Description: generates yield by running an automated covered call strategy

Deposited asset: $ETH

Launch Date: April 12, 2021

Projected APY: 19%)

wBTC covered call.png Vault 2: T-WBTC-C

Description: generates yield by running an automated covered call strategy

Deposited asset: $WBTC

Launch Date: April 29, 2021

Projected APY: 20%

USDC put.png **Vault 3: **T-USDC-P-ETH

Description: generates yield by selling weekly ETH put options.

Deposited asset: $USDC

Launch Date: May 11, 2021

Projected APY: 27%

yvUSDC put.png Vault 4: T-YVUSDC-P-ETH

Description: generates yield selling weekly ETH put options while holding yvUSDC (yield generating USDC) as collateral for extra yield.

Deposited asset: $USDC

Launch Date: July 14th, 2021

Projected APY: 35%

Source

Withdrawals and Fees

The vault allocates 90% of the funds deposited towards its strategy and reserves 10% of the funds deposited for withdrawals. If in any given week the 10% withdrawal limit is reached, withdrawals from the vault will be disabled and depositors will have to wait until the following week in order to withdraw their funds.

Withdrawing from the vault has a fixed withdrawal fee of 0.5%-1.0% (depending on the vault). This is to encourage longer-term depositors. Source

Interesting to note the following. Ribbon distributes withdrawal fees back to existing depositors in each vault which has increased yields for most vaults (especially call selling vaults) as panicking users withdrew funds right once market prices of ETH and BTC were close to strike price. On the ETH covered call option strategy you can see that while premiums have earned the vault 353 $ETH, an additional ≈79 ETH has been earned from withdrawal fees. If the prior data is correct, almost 20% of this vault's yield comes from this withdrawal fee mechanic. Great incentive mechanism for long-term deposits, however, keep in mind once Ribbon V2 is live these performance fees will be paid out to the DAO treasury and no longer directly to depositors. This means lower yields per vault.

Withdrawal fee bonus per vault:

  • USDC-ETH-P-THETA: 268k withdrawal fees/ 1.91m total premium earned | ≈12% bonus from withdrawal fee
  • yvUSDC-ETH-P-THETA: 57k withdrawal fees/463k total premium earned | ≈11% bonus from withdrawal fee
  • ETH-THETA: 78.94 ETH withdrawal fees/ 353 total premium earned| ≈18% bonus from withdrawal fee
  • WBTC-THETA: no data found :/

What are the risks?

Market risk - The main risk involved with depositing funds with Ribbon results from options expiring in the money. This means users can incur a loss from an option sold any given week depending on the price of the asset. To minimize this, Ribbon has done extensive backtests with option strategies to optimize the risk-return ratio of their vaults. Read more about it here

Smart contract risk - As with any DeFi project using smart contract you will encounter smart contract risk. While DeFi is often referred to as “trustless”, a user of a DeFi platform must trust the smart contract they are interacting with. A smart contract could be opaque to a user who is not tech-savvy, which means a user is trusting the contract code in the same way a user trusts the code of a traditional web application.

This could potentially be exploited by malicious smart contract developers although users can protect themselves from this risk by only using protocols that have been audited by the community and professional audit firms. The far bigger risk, however, is that the smart contracts get hacked because of a loophole in the code. This involves not only the smart contracts written by Ribbon but also those used by Opyn (the protocol used to write options) as well as yearn.finance in case you deposit into the yvUSDC put options vault. The Theta Vault smart contracts have been audited by Peckshield, Quantstamp and ChainSafe, some of the most reputable auditors in the DeFi space. Despite that, users are advised to exercise caution and only risk funds they can afford to lose.

Ribbon token, the DAO, and the team behind Ribbon

The founding team behind Ribbon: Co-founder: Julian Koh Cornell University computer science dropout with previous experience at Numerai and as a Software engineer at Coinbase Co-Founder: Ken Chan Background in computer science, also an ex software engineer at Coinbase

What's next for Ribbon?

Ribbon V2: the next version of their vaults coming very soon!

  • Decentralization of Theta Vault operations: automating strike price selection and implementing on-chain auctions for option sales
  • Improved capital efficiency (100% of vault funds are utilized) and users can only withdraw funds after option expiry
  • No more withdrawal fees, switching to a management + performance fee (paid out to the DAO)
  • $RBN Governance rights - enable RBN holders to vote & participate in the vault strategies (ex: selecting less risky strike prices)

more info on Ribbon V2

** Other:**

  • Based on past interviews done by the ribbon team, we also expect more assets like $LINK and $UNI to be added to Ribbon vaults in the future
  • Liquidity mining and sale of the $RBN token
  • Meta-Vault strategies by composing multiple Theta Vaults
  • Creating an ETH vault backed by stETH (Lido.finance stake eth) to boost vault yields
  • Use cases for Ribbons RVOL product including a potential crypto version of the $VIX volatility index

Pros and Con of Ribbon:

  • (+) Product: Strong emphasis on product-market fit and a product-driven roadmap. Exemplified by the user stickiness following the completion of Ribbon's recent liquidity mining program.
  • (+) Appeal to mainstream: Everyone with an understanding of finance understands yields especially when operating with traditional financial strategies using options. I often find myself referring to Ribbon as one of the best examples to explain the innovation enabled by DeFi, smart contracts, and interoperable protocols (aka money legos) to non-crypto users.
  • (+) Team: We believe strongly in the team behind Ribbon and really admire the community ribbon has been able to craft in the past months. On top of this, they are backed by top-tier investors like Coinbase VenturesDragonfly Capital, Joseph Lubin, and Kain Warwick. This might not be an indication of success but definitely is a stamp of approval for the team!
  • (+) Low cost, low effort exposure: Thanks to automatic re-investments each week, you only pay gas once upon depositing which is a big advantage compared to classic yield farming strategies which involve token claim transactions which cost a lot of transaction fees.
  • (+) Automation of option writing: About 6 months ago Ribbon started focussing on decentralizing and automating every aspect of the options writing process. Automation and decentralization of ribbon vaults allow them to scale faster than other competitors and list new assets or strategies with minimal manual effort. More info to come with the release of Ribbon V2.
  • (+) Strong UI and UX, even voted as the best DeFi project in this regard in a recent Twitter thread by @kermankohli
  • (+) Community: After having spent some time in Ribbon's discord channels and seeing the team communicate on twitter I believe Ribbon has managed to build a fantastic community, unlike many other projects I’ve been a part of. Productive contributors, thoughtful questions, and lots of positive interactions. While many Discords are plagued by people discussing price action you’ll find a lot of insightful discussions in the Ribbon Discord. If it’s any metric for the Ribbonatis dedication, Ribbon launched 64 rare ribbon hat NFT’s that were airdropped to early supporters of Ribbon. The last 2 hats traded for $20’000 and $15’000 (source).
  • (-) Market risk for depositors: although Ribbon vaults are designed as a set and forget strategy, oftentimes in volatile weeks depositors are at the tip of their seats when prices near strike prices. It’s worth pointing out that this bears a different risk profile than pure lending or being a liquidity provider in a stable coin pool. There is clear downside potential with Ribbon. If the options Ribbon sold are “in the money”, the vault funds will take a hit. With Put selling vaults you run the risk of losing everything if ETH goes to $0. For both covered call vaults you generally just limit your upside. Say, if ETH goes up by 30% any given week and the price ends up above the strike price. As this vault is denominated in ETH you will still gain from ETH going up that week (profit in $ terms) but you limit your upside compared to just holding ETH.
  • (-) Future competition: As with any open-source crypto project, competitors are not many steps behind if they choose to copy a project. Good examples are Uniswap and Sushiswap. To date, there are very few other (public) players offering structured products in this way but as partnerships are accessible with option protocols like Opyn and Hegic, any project can follow suit. One example could be Hegic (one of the biggest decentralized option protocols). They recently launched automatic option selling for ATM (at-the-money) options including interesting mechanics like auto-hedging. Soon they will also start offering OTM options the same way Ribbon does but let’s see if they can replicate the excellent UX Ribbon offers. We expect many projects to work on structured products with enticing yields to their users utilizing a mixture of options strategies (of which there are many). Other potential projects launching option strategy are StakeDao (recently launched covered call options). All that being said, Ribbon finance has a head start mainly coming from its efforts in decentralization and automation of option writing as mentioned above. Not only will this reduce costs but also allow Ribbon to scale its vaults to a multitude of assets in a short amount of time. On top of that, they have built trust with their users, a strong community, relationships with market makers as well as option protocols. Although other players will enter the options game, I believe the Ribbon team will keep innovating and evolving to stay ahead.
  • (-) Option premium decay: As markets mature and more liquidity enters the options space, I can imagine seeing a decrease in option premiums as assets become less volatile. This would affect yields for options writing for larger assets (BTC, ETH). However, this will take some time to play out and as ribbon plans to expand the assets they make vaults with, we don’t see this being a problem in the short term.

Thank you for reading, please reach out for any feedback or questions! Author

LINKS: Check out Ribbon.finance and start earning yield with options Follow Ribbon on Twitter Join the discussion and ask questions you have on Ribbon’s Discord Deposit via Zerion Ask us questions on Twitter

Fynn

4 months ago ·

14 min read

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