Hegic: A New Age Options Trading Protocol

Hegic is an options trading protocol built on the Ethereum blockchain. Users can buy or sell call and put options using Hegic. It is entirely on-chain, permissionless, and non-custodial – as all DeFi products should be.

What Is Hegic?

Options are a vital building block of financial services. They are the foremost form of market insurance and allow traders to implement robust risk management strategies.

As Ethereum’s DeFi stack grows more diverse, a comprehensive solution to create and trade options is a necessity. Hegic is attempting to cater to that necessity with options that are settled and verifiable on-chain.

When it first launched, Hegic got off to a rough start. But each mishap helped the protocol tweak certain features and make the end-product more resilient.

Using Hegic is reasonably straightforward.

To buy an option on Hegic, investors have to pay the prevailing premium for whichever option they wish to purchase. This option can be exercised at any time, as Hegic’s options specifications follow American style execution.

Source: Hegic

Selling options on Hegic is easier than selling traditional options. All investors need to do is deposit funds into the ETH or DAI pool. Capital in the ETH pool is utilized to sell calls, and the DAI pool to sell puts. 

However, the concept of separate pools to buy and sell options is being phased out for a more efficient alternative.

Source: Hegic

Hegic’s options are more expensive than competitors like Deribit or Opyn. This is because Hegic uses American options that are flexible in execution, while Deribit and others use European style options (can be exercised only at expiry).

This gives options holders the choice of exercising their contracts at any time, rather than hanging on till expiry. It also means option sellers earn a higher premium.

What Sets Hegic Apart from the Competition?

Opyn, ACO Finance, and Deribit are Hegic’s primary competition, albeit Deribit is a centralized alternative and not a direct competitor in DeFi.

As always, there are merits and drawbacks to each of the solutions. Hegic’s benefits lie in its flexibility and simplicity.

Trading options on ACO or Opyn is like trading on a permissionless variant of Deribit, as they all share the same pricing structure. The only difference is that Opyn and ACO do not have liquidity at every strike price. There are a few strikes close to the market price that have sufficient liquidity to take a position.

At the time of writing, Opyn only has one ETH call and three ETH puts. ACO has three ETH calls and three ETH puts. These protocols support options that expire every week and every month.

Source: Opyn

Further, ACO and Opyn have pre-set strike prices. Buyers cannot choose any strike price they desire. But this is the norm in any open options market.

Cut to Hegic. Customers can choose from five expiries: two days, seven days, 14 days, 21 days, or 28 days. 

The expiry kicks in from the minute the option is created, getting rid of the traditional month-to-month or week-to-week expiries for options.

While other options platforms have pre-set strike prices, Hegic’s dynamic pricing model enables it to create options with any strike price. Buying a $435 strike price ETH option is impossible on Deribit. But on Hegic, you can even buy an option with an obscure strike price of, say, $433.15.

This allows traders and hedgers to execute fine-tuned strategies. Customized expiries and strike prices in traditional finance are a privilege only to those with access to OTC markets and vast sums of capital.

But how is Hegic able to bring such a flexible approach to permissionless options? It all boils down to pooled option selling.

ACO Finance and Opyn’s options sellers need to choose a specific strike price and expiry to sell. But on Hegic, funds are pooled and used as liquidity to sell any type of option. 

Currently, Hegic uses an ETH pool to sell calls and a DAI pool to sell puts.

But soon, these pools will be deprecated and replaced with ETH and WBTC pools. In effect, Hegic will have ETH and BTC options on its platform. And each pool will be bidirectional. This means liquidity in the WBTC pool will be used to sell call and put options.

A transition to bidirectional liquidity pools is coming in September. It means that there will be ETH and WBTC pools. Each of them will be utilized for selling both call and put options (in the current model ETH pool is utilized for selling calls and DAI pool for selling puts).

— Hegic (@HegicOptions) August 26, 2020

While this means options sellers have less flexibility in choosing specific strikes and expiries, it also means that providing liquidity to any of the two pools is a market-neutral way of generating yield.

In short, Hegic reduces flexibility for option sellers to further enhance it for option buyers. And this increases the cost of purchasing an option for buyers, thereby offering sellers a higher profit margin.

Risks of Hegic’s Model

Hegic is a fresh take on the options market. But this also means it introduces a different set of risks than traditional options.

For example, implied volatility (IV) is an output from the most popular option pricing method – the Black Scholes equation. However, Hegic’s approach to pricing options renders IV an input in pricing rather than an output.

Data aggregators like Skew collect IV data from Deribit for traders to track. Hegic uses Skew’s reference data to incorporate IV into options prices. Another point of concern is that Hegic manually changes IV when it moves 10%.

Hegic uses the one-month at-the-money IV to price its options, via Skew.

If IV is at 115%, Hegic will only change the input if IV breaches 125% or 105%. This creates an advantage for sophisticated options buyers who can use this model to profit at the expense of Hegic LPs.

A lower IV equates to cheaper options, which favors buyers. A higher IV results in more expensive options, giving sellers a higher premium. If a knowledgeable option buyer can reliably track and predict IV over a short period, they can profit by buying options just before IV increases on Hegic.

This is no simple task, but it’s still theoretically possible and comes at the expense of LPs.

Smart contract risks are another aspect that has proven to be all too real for Hegic. The protocol was deployed on Ethereum and taken off mainnet in the span of a few days after a typo in the codebase rendered options un-exercisable.

Less than a month later, Hegic was exploited through a vulnerability in the protocol’s core design.

In both cases, the team behind Hegic issued 100% reimbursements to users who suffered losses. And each re-deployment has improved some aspect of the protocol.

But that’s not to say that this cannot happen again.

Token Sale and Distribution Details

On September 9, Hegic will launch its native token that works as a cash-flow and governance token. The total supply of 3.012 billion tokens is allocated to early contributors (20%), a development fund (10%), liquidity mining and usage rewards (40%), a bonding curve (25%), and a Balancer pool (5%).

HEGIC will launch at $0.0027 per token. However, this low price is not expected to persist beyond a short period.

The idea behind liquidity mining is to incentivize capital to pile into Hegic. As more funds accrue to Hegic, buyers will be able to execute fairly large trade sizes.

But there is an incentive for buyers to use Hegic beyond its liquidity, as the rewards are split between both sets of Hegic users. Of the 1.204 billion tokens allocated for mining, 80% will be given to liquidity providers (option sellers) and 20% to liquidity utilizers (option buyers).

Hegic’s liquidity mining rewards will be implemented on the new ETH and WBTC pools, as discussed above. Tokens distributed to users and LPs are split equally between the WBTC and ETH pools.

The first phase of liquidity mining entails a daily token emission of 1.32 million HEGIC to liquidity providers and 330,000 HEGIC to liquidity users. The second phase of rewards is slightly lower, with a daily distribution of 990,000 and 250,000 HEGIC to LPs and option buyers, respectively.

Hegic’s IDO was expected to take place on Mesa, but this has changed as community members advised against this platform.