August 11, 2022
Atlantic Strategies: Providing Liquidity for Atlantic StraddlesDopex-EssentialsDopex-Papers
In the previous part of the series (https://blog.dopex.io/articles/dopex-papers/atlantic-strategies-atlantic-straddles) we covered the Atlantic Straddles from the buyers’ point of view. But how should the liquidity providers operate?
HOW DOES IT WORK?
Let us quickly walk through the product’s flow, so that we understand best what the LPs’ exposure is. Let us begin with a small financial mathematics class.
The most important formula
For two options that are ATM (at the money) and have exactly the same strike and time to expiry, the call premium will be equal to the put premium.
That means that a premium for a 3-day put option with 1 ETH of notional and ATM strike will be equal to a premium of a 3-day call option with 1 ETH of notional and ATM strike.
1 ATM call = 1 ATM put
If we adjust the formula further, we can see that:
1 ATM put = 0.5 ATM put + 0.5 ATM put
Note this formula down, as it will be helpful with understanding the rest of this article.
Let us now focus on the lifecycle of the product.
Phase 1 - the deposit phase
In this phase, LPs can deposit their USDC in the contract. The deposit phase is concurrent with the existing epoch - i.e. if you deposit during the live epoch, the deposits will start providing the liquidity only during the next epoch.
Worth noting - the epochs for the Atlantic Straddles are very short term, i.e. 3-7 days. Furthermore, the deposits will automatically roll-over, so once they are in, they keep LPing until the writer chooses to remove their deposit.
Phase 2 - the live epoch phase
During this phase the USDC collateral will be used to sell the Atlantic Puts to the buyers. You may be surprised - Atlantic Puts? Not a mix of Puts and Calls? Yes - the Puts only. Recall the formula we introduced above and let us go through the following example:
- The buyer places an order to buy a straddle for a total notional of 1 ETH (0.5 ETH call and 0.5 ETH put) and pays the premium in USDC
- The pool sells 1 ETH put to the buyer
- The half of the collateral is borrowed by the buyer (50% x 1500 USD = 750 USD) and is used to purchase ETH
The LP’s position is:
- 1 short Atlantic Put
- Premium from selling the Put
- Interest on the lent out portion
The buyer’s position is:
- 1 long Atlantic Put
- 0.5 ETH spot
1 long Put and 0.5 ETH spot will replicate the payoff of a straddle made of a 0.5 ETH call and a 0.5 ETH put - that’s how the Atlantic Straddle works.
Phase 3 - expiration, settlement and rollover
During this phase the buyer’s ETH spot position is sold to USDC, the Put option is settled and the buyer’s USDC loan is repaid back to the LPs.
If any of the LPs queued their deposit for withdrawal, they will be able to do this after this phase. Otherwise, their USDC (adjusted by the profits, losses, interest and premiums) will continue providing liquidity for another epoch.
LET’S TALK SOME NUMBERS
Let us use the following assumptions:
- ETH spot price = 1500 USD
- Time to expiry = 3 days
- Implied volatility = 100%
- Funding rate = 16%
With the above parameters, we will see the following premiums:
- Premium for 1 ETH put = 55 USD
- Premium for 1 ETH call = 55 USD
- Premium for 0.5 ETH put = 27.5 USD
- Premium for 0.5 ETH call = 27.5 USD
For the Atlantic Straddle strategy, the LP will sell 1 ETH put and collect 55 USD (note the premium paid/collected is exactly the same as if 0.5 ETH put and 0.5 ETH call was traded instead).
With the above parameters we can analyze how the payoff will look like. The table below presents it, as well as a corresponding ballpark probability (based on the implied volatility parameters) of the ETH spot price reaching various levels within the next 3 days:
Let us also adjust the table for the funding that will be collected across the 3-day epoch
If we take a closer look at the above tables, we can notice the following:
- The LPs will collect a steady stream of premiums and fundings every 3 days
- The LPs are subjected to a downside risk
Is there a chance to keep LPing and to avoid such a risk?
LPs that would like to protect their downside can do it using a few various strategies:
Hedging with OTM puts
One of the most simple ways to hedge would be to purchase some out of the money put options.
For our example - let’s assume the LP is fairly risk averse and would use ETH puts with a 1400 USD strike (which can be purchased from the Dopex ETH Put SSOV).
The premium for such a put, assuming 3 days and 100% implied volatility would be at ca. 16 USD.
If we check the below table - we can see that such a writer has capped their maximum upside as well as the maximum downside.
Hedging with perps
Another idea is to hedge with perps. As the short put option position will result in losses whenever the ETH spot price moves below the strike price, a writer, feeling a sudden change of heart, can quickly readjust their position using perps.
As we can see in the example below - by opening a short perp position, the writer’s position gets completely inverted - i.e. the downside is completely capped, while the price appreciation will result in losses.
Such a strategy usually needs a more active approach - i.e. to open a short perp position at the writer’s discretion - usually during some unexpected market news
That would be all for today - stay tuned for more articles to guide you through the Atlantic products
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