Call Options

A call option is a building block for the derivatives market. It gives the buyer the right but not the obligation to buy the asset at a specific price (strike) at a specific time.

This page will detail how to create your own call options on UMA.

How options work#

A trader buys an ETH call option with a strike price of 2,000 USD for 0.05 ETH. Now he has the right to buy 1 ETH for 2,000 USD. At the expiry, ETH/USD is at 2,500 USD, and the delivery price is 2,500 USD.

In this case, the option is settled for 500 USD per 1 ETH. At the expiry, the trader’s account is credited with 0.2 ETH (500/2,500), and the seller’s account is debited with 0.2 ETH. The initial purchase price was 0.05 ETH; therefore, the trader’s profit is 0.15 ETH.

If the price of the option was less than $2000 the option will expire worthless. The payout function can be seen as:

Diagram

Getting Started#

Using UMA's infrastructure, a team can create a covered call option using the UMA EMP contract template. These covered calls are European style options which are only redeemable at the time of expiry.

  1. To create your own options you can make use of one of the currently approved price identifiers and collateral types. If your price price identifiers or collateral typesis not approved you can follow our UMIP process to get your specific requirements approved.
  1. You can then launch your contracting by following the EMP launch tutorial. Be sure to include the covered call from our financial product library

With the contracts being cash settled, the terms of the contract remaining constant throughout, and positions always being fully collateralized by definition, there is no need to manage your position or run liquidation bots.

  1. Then to wrap up you should choose the strike price and the starting price of your option. First choose the strike price (the price the collateral will be sold for) and then use an options pricing calculator to derive the starting price. An exmample of such a calculator can be this Black Scholes Calculator.

DeFi Call Option Use Cases#

There are a number of reasons for call options in the traditional financial world. Some of the reasons translate to the DeFi space as well as open new use cases such as:

Leveraged Speculation — The simplest use for a long call position is the ability to speculate on the appreciation of an asset with leverage while also limiting your downside. To obtain the right to be long 1 ETH at a price of 2000 in our example above, the token holder only needs to pay 5% of an ETH. However, the flip side to that is the value of the option will depreciate or decay very quickly to zero if it does not trade above the strike price.

Strategic DeFi Project Uses — Many DeFi projects have distributed their governance tokens either via airdrops or through liquidity mining or developer mining programs. The one downside is many recipients of the tokens may not be long term community members and instead are just looking to dump acquired tokens which could cause a depression in the token price. Distributing a mix of governance tokens and call options could help align the incentives of token recipients by giving recipients a vested interest in contributing to the long-term success of the project.

Better Airdrops and Farms - Options are a popular form of compensation because they align incentives. A token economics benefit is that they only result in sell pressure if the market is bullish. A certain price target is set by the deployer, and option recipients can only cash out if the token price exceeds the strike price at expiry.

Better Bounties - Community managers can control a “slush fund” of call options to pay out to community contributors. The same is true for bounty payouts. Some combination of options and base tokens would guarantee a minimum payout with variable upside. Because these tokens expire, they are well suited to gig work that requires re-upping.

Additional Resources#

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