Valorem Option V1 Motivations and Use Cases

1. Abstract
The following paper proposes a physically executable decentralised-non custodial options protocol for the decentralised finance (DeFi) ecosystem. DeFi power users and crypto users alike must deposit collateral within (ERC20), then will have the choice between exploring vanilla covered calls & puts offered by the protocol to ease users into the learning curve. Further allowing users to write physically executable on any ERC20 token pair, the requirements for writing one of the following options is the following (underlying asset, strike price, expiry date, option type (European vs American style), etc.). Due to the nature of the protocol, the following DeFi option products will allow users to explore multiple new strategies, encompassing hedging, protection against volatile markets, principal-protected note for positions, etc. (The use cases of the following option writing ability will be shown on pg ().)
1.1 Motivation
The inherent increase in volume and capital allocated to the (DeFi) sector in 2021 has confirmed two things; a decentralised financial alternative is in demand from both crypto-users and real-world users alike, the inherent benefits and proof-concept behind (DeFi) has been widely adopted throughout all layers of the ecosystem. The current market for (DeFi) is valued at around 170 billion $ worth of crypto-assets, with year on year growth and further adoption not looking to slow any time soon. The inherent growth of the following sector may be reflected back in the intrinsic search for yield within the central and decentralised financial market. Credit Suisse is currently charging -0.75% on EUR & CHF accounts, FDIC insured bank accounts nationwide or not performing better. The narrative of the '90s 10 -15% interest bearing accounts with (CeFi) entities have long been forgotten. However, earning yields between 10-15% is expected within the current eco-system on ERC20s, despite the associated risks with high yields, (Smart contract vulnerabilities, hard forks, flask crashes in collateral pricing, liquidity issues.). DeFi is still inherently young, and to offer a natural alternative to the current financial ecosystem, more products mirroring the current ecosystem need to be offered to mature the market.
1. 2 The Market for financial products (Options)
In the traditional finance ecosystem, new complex financial products and created by centralised entities daily, with billions in volume to underpin them. A daily average estimated turnover of derivative products was calculated at 1.75 trillion in 2021. The derivatives market contribute the following benefits, hedging optionality, cost-efficient leverage, yield generation, unlimited strategy creation for all market climate types. This leads us to an inevitable conclusion, developing these decentralised financial alternatives is a pre-requisite to global mass adoption from (CeFi) users & entities. This paper will further explain the use of such a derivatives market in the current DeFi ecosystem.

1.2.2 An Example Option Series
In this example, Amadeo wants the ability (option), not the obligation, to sell 1 DAI for one USDT before 11:00PM, Nov 30, 2022. Jon is willing to take the following risk associated with this option; however, not for free. Amadeo must pay to join a fee for this risk known as the premium, in the case 0.10USDT. On the date of the execution of the option, 11:00 PM, Nov 30, 2022, Amadeo may sell his 1 DAI to Jon for one USDT; Jon has the obligation to do so. If Amadeo doesn`t exercise his right, both parties keep their respective assets; Jon has made 0.10USDT (the premium for the risk).

Amadeo is the option owner (or buyer). He is long the option
Jon is the option writer (or seller). he is short the option
DAI, the asset that Amadeo has the right to sell, is called the underlying asset
USDT, the asset that Amadeo receives if he exercises, is called the strike asset
1 USDT, the price at which Amadeo wants to sell DAI, is called the strike price
We call this option a DAI: USDT option and will use this format (underlying asset: strike asset) to refer to option pairs throughout the paper.
0.10 USDT, the sum that Amadeo pays Jon for the option, is the option price or premium
If Amadeo sold his 1 DAI to Jon for 1 USDT on Nov 30, 2022, that is known as the exercise of the option.
Because Amadeo can exercise his option anytime before (or precisely at) 11:00 PM on Nov 30, 2021, this type of option is known as an American option. If instead, Amadeo could only exercise his option precisely at the time of expiry and not before or after that time, this option would be known as a European option.
Because Amadeo has the right to sell DAI, this is called a put option. If, instead, Amadeo had the right to buy DAI from Jon, this would be called a call option.
Source: infographic 1

The following example is a fundamental (Vanilla) concept of how two individuals could structure an option between themselves. Further, the terminology is used within the derivative sector. Infographic one summarises the key use of options within the DeFi ecosystem that would drive users to incorporate the following in their toolset.

1.3 Valorem (Introduction)

Valorem Options V1 is a DeFi money lego enabling writing covered calls and covered puts. These will be physically settled, American or European style options. All written options are fully collateralized against an ERC-20 underlying asset and exercised with an ERC-20 exercise asset. The creation and proposal of the following protocol were due to a lack of availability & customisation in the current (DeFi) ecosystem due to an inherent lack of mature alternative products. Valorem`s permissionless option protocol will allow for the creation of unlimited optionality in a severely lacking decentralised derivatives market.

1.3.2 Valorem Mechanism:
Valorem functions on the following mechanics, it allows users to write any covered call & put it on any underlying ERC20 pair. The pre-requisite to this is the following, All written options are fully collateralised against an ERC-20 underlying asset and exercised with an ERC-20 exercise asset. A Chainlink VRF random number per unique option type is used; settlement is fair, provably randomised and most importantly decentralised. Options contracts are issues using a fungible ERC-1155 token (Each fungible token representing a contract). Option writers are issued ERC-1155 NFT; this represents a lot of contracts written for claiming collateral and exercise assignments. The core benefit of the following model is that it eliminates the need for market price oracles whilst allowing for permissionless writing, gas efficient transfers, of a broad range of traditional and exotic options.

1.4 Case studies (Use Cases)
Hedging principle:
Consider a put option series for 1 DAI, at a strike price of 0.99 USDT, which expires at 11:59 PM on December 31, 2019.
If Amadeo wants to mint and sell exactly one V-Token of the above put series, he must put down exactly 0.99 USDT as collateral in a vault. After specifying the desired option series’s attributes as parameters, a new put option V-token is minted to the issuer's address. The token can then be sold to any buyer through any ERC-1155 compliant DEX or through the Valorem protocol.

Amadeo may then sell the V-token (Option contract) to Jon at the market rate of 0.10 USDT (Premium per contract), the 0.10 USDT being the chosen collateralised asset. Since the V-token is an ERC-1155, the sale can happen on any ERC-1155 compliant Dex or exchange of Amadeo’s choice, premium may be collected in the asset choice of Amadeo,(yield generation strategy). As long as Jon holds the V-token that he has purchased, it gives him the right to exchange 1 DAI for 0.99 USDT (before) 11:00 PM on November 31, 2021 (European style option).

Before November 30th, the price of 1 DAI falls drastically to 0.50 USDT, which is below the option’s strike price of 0.99 USDT. This leads to a significant loss of sale on any dex & cex 1DAI = 0.50USDT market value. However Jon owns the put option, he can exercise it to sell his 1 DAI to Amadeo for him 0.99 USDT of collateral. If Jon exercises his V-token, he limits his loss to one USDT cent (strike price of 0.99 USDT, compared to the 1 USDT that he paid for the DAI). This significantly protected him from unforeseen market volatility and allowed him to hedge himself.

Principal protected notes:

Principal protected note by depositing dai into alchemix, then borrowing the future yield, and using it to buy an out of the money call option on eth, or a put.
Bull market strategy:
Leverage Valorems V-token (ERC-1155 fungible token), following strategy functions through the sale of 7-day European call options (ERC20 calls), preferably liquid pairs, (ETH, BTC, AAVE, UNI…). The following option is collateralised fully by DAI. Contract & protocol users sell calls via Airswap or Valorem to other users or market makers; the premium received for the sale of calls generates a consistent weekly yield, generating estimated APY depending on market sentiment. (Underlying collateral can be put to generate yield in Valorem passive ETH strategy).
Example: Amadeo decides to use the following ETH Call strategy; he sells call options on ETH collateralised by DAI exercisable before the 30th November 2021. setting the strike price close to his risk tolerance relevant to the current market conditions. The strike price of the option is 4200$ per ETH; the premium per option contract is $0.15 per contract or 20% of the option premium per contract. As long as the option doesn`t go above the strike price during the duration of the derivatives span, the premium will be attributed to Amadeo, generating a consistent yield.

bear market strategy:

Leverage Valorems V-token (ERC-1155 fungible token), following strategy functions through the sale of 7-day European put options (ERC20 calls), preferably liquid pairs, (ETH, BTC, AAVE, UNI…). The following option is collateralised fully by DAI. Contract & protocol users sell calls via Airswap or Valorem to other users or market makers, the premium received for the sale of puts generates a consistent weekly yield, generating estimated APY depending on market sentiment.

Example: Amadeo decides to use the following ETH Put strategy, he sells put options on ETH collateralised by DAI exercisable before the 30th November 2021. setting the strike price close to his risk tolerance relevant to the current market conditions. The strike price of the option is 2200$ per ETH, the premium per option contract is $0.15 per contract or 20% of the option premium per contract. As long as the option doesn`t go below the strike price during the duration of the derivatives span, the premium will be attributed to Amadeo, generating a consistent yield.

a crab/sideways strategy:

Vesting period, option token unlock for dao`s & protocols
Vesting period option writing for protocols and decentralised organisations has always been a complex issue. The allocation and vesting periods, further the on-chain management have led to creators and developers losing time further. Valorems option writing changes the narrative, Options writers can allocate V-Tokens ( ERC-1155 fungible tokens) to team members and advisors etc, with specific vesting periods allowing redeemability to be based on an American option style.