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FTX IEO | What is the American option protocol PsyOptions, how does it work, basic strategies, and token economics.

2022/1/14

Last week, FTX announced the first IEO of 2022: PsyOptions. According to the official whitepaper, PsyOptions is a decentralized options protocol on Solana. This article will provide a detailed introduction to PsyOptions: what are options, how does PsyOptions work, and what are some basic options strategies? PsyOptions is built on the options protocol on Solana, offering a flexible, permissionless development framework. Traders can use PsyOptions to freely create options for various assets such as NFTs and tokenized equities, and price them accordingly. The initial version focuses on American-style options v1, with plans to introduce European-style options in the future. With PsyOptions, traders can tailor specific trading strategies for designated assets, including long positions, short positions, hedging, arbitrage, risk mitigation, etc. This is a crucial component in Solana's DeFi ecosystem, enhancing the composability and sophistication of on-chain financial products. American and European options differ in execution. Both give the buyer the right, but not the obligation, to exercise the option. However, holders of American options can exercise the option at any time before the expiration date at the strike price, resulting in a delivery at the strike price, while European options can only be exercised at expiration. American options trading is more flexible and therefore more popular among retail investors, with higher trading volumes. Additionally, American options settle in "physical assets," providing liquidity for the underlying asset.

Table of Contents

How Does PsyOptions Work?

PsyOptions' options issuance structure has five main parameters: underlying asset, quote asset, contract size, strike price, and expiration date.

According to the whitepaper, to create options products, a specified amount of assets must be locked in the contract (100% collateralization for American options v1), and after collateralization, the creating user will receive two tokens: 1. Option tokens and 2. Writer tokens (referred to as equity tokens).

The option token represents the "actual contract," giving the holder the right to execute the contract at the agreed price; the equity token represents the seller's asset rights, allowing the seller to redeem the remaining assets in the contract after the expiration date.

For example, if the current price of SOL is $137, and Xiaoban believes that the market conditions are neutral to bearish, she can issue SOL options using PsyOption.

Based on the aforementioned five parameters, Xiaoban issues SOL options with USDC as the quote asset (SOL/USDC), a contract size of 100 SOL, a strike price of $150, and an expiration date of January 31st. After collateralizing 100 SOL into the smart contract, option tokens and equity tokens are minted.

Now, Xiaoban can sell the option tokens to those who believe SOL prices will rise, such as Xiaona, while holding the equity tokens herself.

Subsequently, if the SOL price rises to $170, Xiaona can exercise the option token to purchase SOL at $150; if the SOL price falls, Xiaona can choose not to exercise the delivery right, and her loss would be the amount she paid to buy the option token. Xiaoban, on the other hand, can redeem the 100 SOL using the equity tokens at the expiration date, making a profit from selling the options.

It's important to note that option issuers (equity token holders) may not always be able to redeem all collateral assets locked in the smart contract. If someone settles early, equity token holders can only redeem the remaining assets after expiration. This is due to the high volatility in the crypto market, where option token holders may exercise their rights, settling for profits.

Using the same example, if Xiaoban had 100 SOL collateralized in the smart contract, and someone else had already redeemed 60 SOL using option tokens, Xiaoban would only receive back 40 SOL.

Introduction to Basic Options

Having understood the mechanism of PsyOptions, the author will further explain the utility of options in the financial market.
Options (OP), also known as derivatives, allow the holder to buy or sell assets at a specific price within a specific time frame. Unlike spot trading, options have expiration dates and strike prices.
The two basic types of options are calls and puts (bullish and bearish options in China).
A call option allows the holder to buy assets at a specific price before the expiration date; a put option allows the holder to sell assets at a specific price before the expiration date.
There are four basic trading strategies:

Buying a Call: Expecting a price increase
Selling a Call: Expecting no significant increase (neutral or bearish)
Buying a Put: Expecting a price decrease
Selling a Put: Expecting no significant decrease (neutral or bullish)

Each trader has different market opinions. While trading spot or contracts, investors may only enter the market when prices rise or fall. Options, on the other hand, are more flexible, allowing investors to create strategies based on market views and risk management.

Using the example above, if Xiaoban predicts correctly, she can receive the premium from selling the option token at settlement while recovering the principal (collateral assets). Even if investors predict significant price movements, options allow them to amplify profits with minimal capital.

PsyOptions' Strategic Combinations

According to the PsyOptions whitepaper, option trading strategies include the following.

For anticipating a price increase, one can:

Buy a Call: Grants the buyer the right to buy the underlying asset at a specific price before a certain expiration date.
Sell a Secured Put: Sell a put option to earn a premium while locking enough cash to purchase the underlying asset, suitable for short-term bearish and long-term bullish strategies.
Bull Call Spreads: Buy a call with a lower strike price, expecting the asset to reach at least that price; sell a call with a higher strike price, believing the asset won't reach that price, and profit from the difference.

For expecting a price decrease, one can:

Buy a Put: Grants the buyer the right to sell the asset at a specific price before a certain expiration date.
Sell a Covered Call: Hold the same position of assets, sell a call option to earn a premium, suitable for stable price conditions where the asset won't rise to the call option's pricing.
Execute a Bear Put Spreads: Buy a put with a higher strike price, sell a put with a lower strike price.

For anticipating significant price volatility, one can:

Execute a Protective Collar: Hold the asset, buy a put and sell a call. The premium from the call option can cover the put option, protecting existing positions in case of short-term price drops.
Execute a Long Straddle: Simultaneously buy call and put options with the same strike price and expiration date, paying premiums for both. Profits are possible with significant price movements in either direction.
Execute a Long Strangle: Simultaneously buy call and put options with different strike prices. This strategy is for traders anticipating significant price movements in either direction (but uncertain about the direction).

For expecting price stability, one can:

Sell a Covered Call: Hold the same position of assets, sell a call option to earn a premium, suitable for stable price conditions where the asset won't rise to the call option's pricing.
Sell a Secured Put: Sell a put option to earn a premium while locking enough cash to purchase the underlying asset, suitable for short-term bearish and long-term bullish strategies.
Execute a Long Call Butterfly Spread: Sell a combination of spreads (price at K) + buy a call (>K) + buy a put (>K). This strategy effectively controls downside risk and is favored by many institutions for generating profits during consolidation.

These strategies are only suggested by PsyOptions, and in reality, there are many more combination strategies for options beyond these.

Token Economics

The token issued by the PsyOptions protocol is PSY.

PSY is a governance token. Users holding PSY tokens can propose and vote on-chain using PSY tokens. According to the whitepaper, PSY serves two functions:

Managing smart contracts
Managing the Treasury

The PsyOptions protocol will allocate fees for 1. minting tokens (option tokens, equity tokens), 2. trading on the Serum DEX, and 3. interacting with other protocols to the Treasury. The funds in the Treasury will be determined by community (PSY holders) voting.

Based on the voting experience of other protocols, the funds in the Treasury will eventually be distributed back to the community, possibly through profit-sharing, rewarding stakers, or incentivizing liquidity providers. It's worth noting that the team does not currently have a staking mechanism, but this can be changed through governance proposals in the future.

According to the token distribution in the whitepaper, the DAO Treasury will be allocated 60% of the PSY tokens, which will be unlocked through governance proposals to develop the PsyOptions ecosystem.

PSY Token Distribution Details

The total supply of PSY tokens is 1 billion, and the token type is SPL, with an initial circulation of only 6.2% of the total supply, 62 million PSY tokens.
Details are as follows:

Governance

PSY is purely a governance token, giving holders the power to upgrade the PsyOptions protocol. However, the voting mechanism will be subject to DAO constraints and checks and balances principles to prevent a single or minority holder from controlling the protocol's direction.
The governance model of PSY follows the industry's gold standard: the governance model of the COMP token. Anyone holding 0.1% of the tokens (1 million PSY) can participate in governance.

Governance proposals can be complex or simple, such as adding new options products, changing collateralization ratios, or adjusting market rates. These proposals are code and will affect not only the protocol itself but also other protocols created by PsyOptions DAO, including the initial launch of American options v1 and the upcoming European options v1.

The team specifically notes that since proposing governance requires at least 2% of the tokens, and with only 6.2% initial circulation, operations may be adjusted accordingly.

Conclusion

In the financial market, each trader has different market views, and the advantage of options lies in meeting the needs of all traders.

As Solana's on-chain assets become more diverse, the need for various trading strategies increases to cater to demands, even attracting more traditional financial professionals. These complex strategies are not executable on centralized exchanges.

The PsyOptions protocol is open and has no predefined stance on options assets, pricing, or trading methods, allowing users to develop different options according to their needs, such as NFT property divisions and equity tokens. This flexibility provides users with more options to create different strategies for various assets.

PSY tokens in PsyOptions are SPL tokens, enabling integration with other protocols on Solana. For example, option tokens and equity tokens can be used for collateral borrowing in other protocols in the future or provide liquidity for certain assets, such as NFTs or equity tokens. PsyOptions injects flexibility and adaptability into the Solana DeFi ecosystem, introducing more product strategies that are well-suited for execution on Solana with low fees and high TPS.