This article will provide an overview of the current DeFi options landscape, and summarise the Lyra finance protocol in a way that is hopefully understandable for someone with even the most basic understanding of options trading. Lyra is building the first option protocol rivaling centralized exchanges - learn what makes it special and how you can become an option trader and market maker today!

The current state of DeFi options

Throughout 2021, we saw clear demand for derivatives in DeFi. The opportunity for additional leverage, risk management and sustainable yield propelled a number of protocols to the forefront of the industry.

This was most evident with the explosive growth of dYdX, a decentralized exchange for perpetuals that launched on StarkEx, a ZK rollup solution. In late September, dYdX briefly overtook Coinbase in derivatives trading volume with a $4b dollar trading day, showing the willingness of traders currently using centralized exchanges to use DeFi if there is enough parity in the trading experience.

Since the dawn of DeFi, there has been a constant mutter within the community “Do options make sense in DeFi? If so, why haven’t they found product market fit?” ~ one of the largest financial markets in the world, yet to find more than mediocre traction on-chain. Today, options in crypto are synonymous with Deribit - the leading options exchange accounting for ~90% of all notional volumes in BTC and ETH, however there has yet to be a platform for trading options to reach this level of traction in DeFi.

While not precisely option exchanges, a new cohort of options protocols have emerged in the interim that offer an alternative form of yield to vanilla yield farming and staking by providing access to options premiums. Protocols like Ribbon, Dopex, Premia and StakeDAO are able to offer their users sustainable ‘yield’ by bundling complex option trading strategies into a single 1-click deposit format, known as a structured product. These products are innovative since they offer a unique kind of yield that does not come from token issuances a.k.a yield farming, asset lending or trading fees, but rather from earning a premium for selling call or put options. This growth in the DeFi options market was captured in a recent report from Delphi Digital, which can be visualized in the graphic below.

So far options protocols on the market seem to be satisfying the desire for passive yield, but there is still no consistent, reliable platform to actively trade options with deep enough liquidity to rival Deribit. Lyra is the only decentralized options exchange right now that can facilitate the sale of options back into a liquid market via the AMM - alternatives only allow the option holder to expire the options early (american style options) or wait for the option to mature to the final expiration date. This is an important mechanism for traders, as more views can be expressed by buying and selling options instantly with liquidity, such as harvesting volatility risk premiums.

Lyra aims to become the go-to destination for actively trading options that is competitive with any centralized exchange. This requires a few things which Lyra has brought on chain for the first time:

• The ability to buy and sell both calls and puts, instantly
• Pricing that is ‘accurate’ and in line with centralized exchanges
• Providing traders with deep, consistent liquidity
• Ensuring LPs are not exposed to extreme risk

What makes Lyra different?

In the latter half of 2021, Ethereum scalability and alt L1’s became a point of discussion and contention in the community. Lyra is an options protocol built natively for Ethereum Layer-2, accessing a design space that is unbounded by the constraints of an L1. This allows new approaches to hard problems like options, which have complex pricing and risk mechanics that require the scalability of a Layer-2 environment. As previously mentioned, many options strategies involve both buying and selling options. Lyra is the only live options protocol that allows traders to buy and sell both calls and puts, a necessity to offer a complete options trading solution.

Accurate pricing

Lyra is the first project to achieve options pricing that is comparable to centralized exchanges. This is drastically important, no trader will want to purchase an option that is orders of magnitude more expensive than the equivalent option on a centralized exchange. Lyra is able to achieve a bid-ask spread (the difference between buying and selling the same option) that is almost inline with Deribit, which has never been achieved on-chain before.

As outlined in the whitepaper, Lyra can provide on-chain pricing by using the market demand and supply to map the implied volatility surface per expiry. When a new strike is listed, a baseline volatility input is initiated along with ratios of the listed strike volatilities (skew) from the market rate for at-the-money strikes. After initialization the base IV and skew are determined through the supply and demand in the market via a standard size which allows the AMM to contextualize each trade and alter its pricing parameters in proportion to a trade’s size. In more simple terms, the larger the trade, the greater the impact that trade has on the pricing of that option series. With every trade, the IV and skew are updated according to the standard size parameter to ensure that pricing is accurate across the board. This surface is then fed into the Black Scholes pricing model, the most popular mathematical equation to estimate the “fair” price of an option, to determine prices for all listed options, yielding performant pricing for traders and steady returns for LPs.

Reliable, deep liquidity

It is important that traders always know that they can come to Lyra and find liquid, efficient markets to trade options. Imagine coming up with a great options play, or needing to hedge some downside risk with a longer dated option that may be out of the money, and finding that there was little to no liquidity available to trade. Lyra provides a reliable destination for traders to find the options they want to trade with the right depth.

On Lyra, LPs do not need to specify strikes or expiries to provide liquidity, only which market they would like to participate in (i.e. ETH, BTC). This is because liquidity is unified across strikes and expiries with a dynamic volatility surface, drastically improving the trading experience.

Risk management for LPs

It’s no secret that options markets are very risky, and in the past option LPs have been exposed to unacceptable blowup risk as LP’s need to honour the redemption price of the options they underwrite. Options market makers often want to be ‘delta-neutral’ which means they are not exposed to any directional fluctuations in the price of the underlying asset, but rather they are simply earning consistent profits from traders buying and selling options (the bid-ask spread). In the same way, the Lyra system has been designed so LPs are not exposed to directional movements (resulting in IL) but are simply earning the spread of traders in the market as revenue, much like market makers in traditional finance.

Lyra uses Synthetix to hedge the delta risk of its LPs (live in Q1 2022). As trades occur on Lyra, LPs take on exposure of the underlying asset. To protect LPs, the Lyra AMM quantifies the net delta risk of the AMM and initiates a hedging trade, long or short on the underlying asset via Synthetix. This action is completed by external keepers who are incentivised to execute the hedging trade once the net-delta of the AMM goes beyond a certain threshold. Vega (volatility) risk is quantified and is a key input into the AMM’s fee structure for pricing options, allowing it to incentivize risk-reducing trades. If the pool is long volatility, the AMM dynamically increases or decreases the price of options to incentivise users to execute trades that reduce the vega risk of the pool. These innovations increase the alpha and improve the Sharpe ratio of the AMM. Read more about the hedging mechanism here.

Why should you trade options in the first place?

When asked the question, why options? More often than not my answer begins with placing options trading into two broad buckets;

1. Retail traders who gaining access to liquidation-free leverage to make directional bets, along with simple portfolio hedging

2. Institutional/sophisticated traders who use options to hedge large portfolio positions or make markets earning profits on the bid-ask spread.

Options are versatile tools that allow traders to construct creative and complex payoff structures to benefit in bull, bear, or even crab markets.

For a basic options primer and some useful options strategies, head over to the Lyra docs here.

Retail traders

Options have been in the spotlight in the past few years with a dramatic increase in retail trading volume on platforms like Robinhood since TradFi brokerages squashed commissions in 2019. Options give traders access to make leveraged trades to speculate whether an asset will move up or down without the risk of liquidation. Options have a payoff structure that can provide theoretically infinite returns if the asset moves in the desired direction which has led to the famous success stories of outsized returns on meme stocks in traditional markets on forums like r/Wallstreetbets.

Retail traders can also use Options as a great hedge against downside portfolio risk by buying long puts or setting up strategies like spreads. If an individual has a significant exposure to price fluctuations in ETH, they may buy ETH puts - understanding that they may sacrifice some profit in the short term, but are actually purchasing ‘insurance’ to cap downside losses in a bear market.

Institutional traders

Institutional players use options to the hedge exposure of large positions. Similar to retail investors, institutional sized traders (whales as we know them) want to minimize their downside exposure and often use options as insurance against downside price fluctuations. You can read more about advanced strategies for trading options in our resources here. Institutions may also sell covered calls and short puts (similar to a vaults strategy) to earn income over time, or use options for directional speculation. Institutions also may employ more complicated strategies like spreads, strangles and condors to create tailored outcomes.

How to trade on Lyra

Walkthrough video guide

Step 1: Add Optimistic Ethereum to your wallet Lyra is the first project built natively for OE. If you have never used OE before you will need to add the Optimistic Ethereum network to your wallet. You can use chainid.link to add the network to your wallet with a single click.

Step 2: Bridge ETH from Mainnet to Optimism After you have added the Optimistic Ethereum network, you will need to bridge funds from the Ethereum mainnet to Layer 2. The easiest way to do this is via the Optimism Gateway. This process is similar to bridging funds to other chains i.e. Polygon. You can watch a walkthrough for the Optimism gateway by Bankless here.

Step 3: Connect your wallet to Lyra Head to https://app.lyra.finance/ and connect your desired wallet to the dApp

Step 4: Select an expiry Options don’t last forever, though, they have an expiration date. After this date, the holder can no longer buy or sell the asset at the strike price and the option is worthless.

You can select your desired expiry using the dropdown on the trade page.. The list of strikes will update to reflect the available options for your selected expiry.

Step 5: Select “buy” or “sell” Lyra’s AMM allows traders to buy and sell options. Traders who buy options are called holders and traders who sell options are called writers of options. You can easily toggle between buying and selling on the trade page.

Step 6: Select “call” or “put” A call option gives the holder the right to buy a token and a put option gives the holder the right to sell a token. Traders who are bullish can buy a call or sell a put, whereas if they're bearish, they can buy a put or sell a call.

Step 7: Select a strike price On Lyra, one option covers one unit of the underlying token. This is different from traditional stock options which often cover 100 shares of the underlying stock. The scalability of the Lyra mechanism means that there is no lower limit of options order size, making the system accessible to all traders in the community.

Step 8: Acquire sUSD and Synths Lyra’s mechanism uses Synthetix as a spot market to trade in and out of the underlying asset, and therefore requires synths to buy or sell options. You’ll need sUSD, a synthetic stablecoin, to open long positions and short puts, and you’ll need sETH as collateral for short calls. The best way to acquire sUSD is on Optimistic Uniswap. The best way to acquire synths for collateral is to use sUSD and head to Kwenta to swap for sETH, sBTC or sLINK.

Enter the quantity of options you wish to purchase or sell and approve the transaction in Metamask. You can toggle between calls and puts on the trade page.

Step 9: View your positions on the ‘Portfolio’ page The Portfolio page shows you your current positions as well as the unrealized profit and loss for those positions. You can close any open positions by pressing the “Close” button. This will give you more information about the closing trade, including incurred fees. When your positions expire, you can settle them in the “Expired Positions” tab.

How to Provide Liquidity

Providing liquidity on Lyra allows you to become a market maker. In traditional options markets, a counterparty acts as the market maker, filling orders on the other side of trades to ‘make markets’. On Lyra, the AMM is able to act as this intermediary rather than a large institution, allowing anyone to make markets and earn fees/premiums as a Liquidity Provider. Currently liquidity is locked into month long rounds, this restriction will be removed with "anytime entry and exit" with the Avalon release (more on Avalon release later).

During the ignition phase, APR for the Lyra market pools was ~65% at a LYRA price of $0.35c. With the current emissions schedule outlined in the LEAP-13 governance proposal, indicative APRs with target TVL, the APR for the options market pools will be around ~35% along with profits earned from trading fees (which should increase with a higher pool utilization rate). Before considering depositing, it is essential to understand that providing liquidity carries a number of risks. You can check out a detailed description of the risks here.

Step 1: Choose a market Decide which market you’d like to LP

Step 2: Approve sUSD Open the earn page for the Lyra ETH market and press "Deposit”. If you don’t have sUSD, you will be prompted to swap to sUSD. Press "Allow Lyra to deposit your sUSD" to allow Lyra’s liquidity pool contracts to deposit your sUSD.

Step 3: Click ‘Deposit’ Finally, press “Deposit” to deposit your sUSD to the pool. You will be given a liquidity certificate representing your deposited sUSD. You can view your liquidity certificates on the ETH pools page.

Please note: All certificates will be marked as “Waiting for the next round”. When the next round starts, your certificates will become locked for a 2 week round. This means they are being used by the AMM and are earning Lyra rewards.

LYRA Tokenomics

On December 14th, the LYRA token went live as the first token to launch natively to L2. LYRA was earned by traders, LPs and the community over a 6 week period leading up to the token unlock called ‘Ignition’. After January 7th there will be three use cases for the token.

• Can be staked in the Security Module (SM)
• Can be used to vote on Council elections
• Can be staked in the LYRA-ETH Uniswap pool to earn LYRA rewards

Beyond these functions, the most powerful path for the LYRA token is to build an emissions and staking system that deeply integrates token functionality with trading volumes and market liquidity. This path will drive tokens into the hands of community members, traders, and LPs who are long-term aligned with the protocol. Soon, users will be able to stake their LYRA in return for xLYRA which acts as a rewards boost for trading and liquidity providing. The idea for this implementation is inspired by Curve’s veCRV token.

Vision for Lyra: the Avalon release

2022 will be a huge year for the Lyra protocol. As outlined in our 2022 roadmap blog, a new and even more powerful version of the Lyra protocol will launch in Q1 of this coming year. Avalon will greatly improve the UX for both LPs and traders, strengthening Lyra’s foothold as the go-to location to trade options in DeFi.

This version of Lyra will accommodate:

• Regular 1, 2, 3, 4, 6, 8, and 12 week expiries with up to 15 strikes per expiry, renewing every two weeks
• Partially collateralized options selling
• Any time entry and exit to the liquidity pools, subject to a short delay
• All of the existing features of Lyra (buy/sell options to pool, on-chain price discovery, delta hedging)

While significant, the Avalon release is just another step on the long road to bringing a robust options market to DeFi. With structured products, more token utility and more assets to trade on the horizon, 2022 will be a huge year for the Lyra community. We encourage you to try out the dApp and have a trade, join the community and check us out on Twitter.

May 2020

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