Lyra is a decentralized finance (DeFi) protocol that makes markets (provides liquidity) in decentralized options contracts with automated market maker (AMM) technology. In this article, we will explore how the Lyra protocol works and some of its key features.
What Are Automated Market Makers (AMMs)?
AMMs like Uniswap are the backbone of DeFi. Users that wish to buy or sell crypto in DeFi connect to a decentralized exchange (DEX) and tap into whatever liquidity pool they are trading. For example, if you want to buy ETH and sell USDC, you would access the ETH/USDC pool, which is stored on a smart contract.
So who provides the crypto in these pools that you are trading from? Anyone can be a ‘liquidity provider’. All you have to do is deposit an equal value of two cryptocurrencies into a liquidity pool. As traders trade from this pool, you earn fees!
AMMs are different from traditional finance (TradFi) which employs order books and market makers (Citadel, Virtu) to provide liquidity.
Advantages of AMMs
- Always liquid – there is always crypto in the pools to trade;
- No middlemen – liquidity is provided by users;
- Lower fees – no need to pay traditional market makers.
Disadvantages of AMMs
- Impermanent loss – risks for liquidity providers;
- Higher slippage – large orders move price more.
Lyra: An AMM for Options
Lyra takes the Uniswap AMM model and tweaks it for options trading. However, making markets in options is much more complicated than making markets in spot crypto, like Uniswap. This is because options are derivatives – their prices are contingent upon a separate underlying asset.
Because of this, options are incredibly sensitive to many things. In options trading, these sensitivities are divided into the four ‘Greeks’:
- Delta: How much crypto do the options represent at any given time?;
- Theta: How fast does the option decay over time?;
- Gamma: At what rate does the Delta change?;
- Vega: How sensitive is the option to changes in the underlying volatility?.
Lyra is one of the first DeFi protocols to price options almost as well as traditional market makers – who have much more versatility. They’re not there yet, but they’re getting closer with every upgrade.
Challenges for AMM Options
There are some key challenges Lyra has had to solve:
- Pricing options accurately;
- Managing risk for liquidity providers;
- Preventing manipulation.
Lyra continues to innovate on their models to solve these problems.
Innovation with AMM Options
Some key innovations Lyra introduced:
- Dynamic automated market making – prices update in real-time;
- Option portfolio management – tools to hedge risks;
- Virtual AMMs – simulate trades before executing.
How Does Lyra Work?
To trade options on Lyra, you will first need to connect your self-custody crypto wallet like MetaMask to the protocol.
You will next need to bridge to one of two supported layer 2 Ethereum-based blockchains:
- Arbitrum;
- Optimism.
As of August 2022, Lyra supports only Ether (ETH) and Bitcoin (BTC) options.
Here are the key steps to trading options on Lyra:
- Connect your wallet;
- Bridge assets to Layer 2 (Arbitrum / Optimism);
- Select the market (ETH or BTC options);
- Choose strike price and expiration date;
- Buy or sell options contracts;
- Close positions or exercise options.
Some key features of the Lyra interface:
- Virtual AMM – Estimate price impact before executing trades;
- Leveraged positions – Open positions larger than your collateral;
- Bundles – Group options contracts together.
Lyra: Selecting a Strike Price
One of the most important choices when trading options is selecting the strike price – the price at which you can exercise the option. Here are some key factors to consider:
In the Money vs Out of the Money
- ITM – Strike price below current price (call), above current price (put). More expensive upfront but higher delta;
- OTM – Strike price above current price (call), below current price (put). Cheaper upfront but lower delta.
Risk vs Reward
The further OTM, the cheaper the option, but lower delta. The further ITM, the more expensive, but higher delta. Strike price is a key risk vs reward decision.
Market Forecast
Consider where you think the market is headed when choosing a strike. Bullish? Choose higher call strike. Bearish? Choose lower put strike. Strike price reflects market prediction.
Collateral Limitations
The more collateral you have, the more flexibility in choosing strikes. With less collateral, may need to choose closer OTM strikes.
Conclusion
Lyra brings automated market making to decentralized options trading. With its focus on risk management, pricing models, and usability Lyra is pushing DeFi options forward. There is still much work to be done, but Lyra is proving AMMs can work for options.