Thread by @TreehouseFi

Not many know this: DeFi Option Vaults (DOVs) have gained tremendous popularity over the past few quarters. The potential for DOVs to revolutionize DeFi in the coming years is HUGE.

Learn more 🧵👇

#WebTr3e 🌳 #DeFi #DOVs #Options

What are DOVs? 👀

DOVs are automated vaults that use options as their underlying product to generate returns. At its peak, DOVs accounted for >$500M of the total #TVL in #DeFi options.

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2 reasons why DOVs are a force to be reckoned with:
1️⃣ DOVs democratize complex options strategies to the masses
2️⃣ DOVs bring high organic yield to DeFi

We believe that DOVs will shape the #DeFi space moving forward. 🚀

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2 main strategies that DOVs currently use:
1️⃣ Covered Call
2️⃣ Cash-covered Puts

DOVs collect premiums by selling #options to interested buyers. This forms the base of the yield that the vault generates.

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1️⃣Covered Call Strategy

You hold onto an asset and sell an out-of-the-money (OTM) call option on it. If the call option expires OTM, you keep the asset and the premium received from selling the option.

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Vice versa, if the option expires in-the-money (ITM), you must deliver the asset to the call buyer at the option’s strike price. In the case of DOVs, you’ll settle the difference instead of delivering the asset.

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Here's what OTM and ITM are:

OTM Call Option: strike > spot
OTM Put Option: strike < price

ITM Call Option: strike < spot
ITM Put Option: strike > spot

A call option grants the holder the right to buy, while the put option grants the holder the right to sell.

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2️⃣ Cash-covered Put Strategy

You hold on to cash (#stablecoins) and sell an OTM put option on it. If the put option expires OTM, you can keep the cash and the premium received on selling the option.

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Similarly, if the option expires ITM, you must purchase the reference asset from the buyer at the option’s strike price. In the case of DOVs, you’ll settle the difference instead of delivering the asset.

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In the context of DOVs, both strategies require the investor to deposit the respective asset. i.e. the underlying token for covered calls and the stablecoin for cash-covered puts

DOVs are automated, so you don’t have to select any option’s strike price or tenor.

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Sounds great, right? Remember that, like many innovations out there, DOVs face early difficulties.

1️⃣ Capital Inefficiency
2️⃣ Front-running of DOVs
3️⃣ Underperformance and Buildup of Risk

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🌳 Capital Inefficiency

The majority of DOVs require investors to put up full collateralization. This means that investors’ collateral is locked up in the vault, resulting in lost opportunities for yield generation elsewhere and difficulty in exiting the vault.

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Thankfully, several DOV #protocols are now reducing depositors' collateralization level and introducing tokenization of vault positions for easy entry and exit. 🙏

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🌳 Front-running of DOVs

Currently, most DOVs auctions are public information, meaning that opportunistic volatility trades can sell options ahead of DOVs to capture the fall in implied volatility (IV).

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Option prices will fall due to lower IV, resulting in lower premiums generated by DOVs. This is a problem that DOVs have been tackling since the early days. New solutions, such as randomized auctions, are constantly being developed to mitigate the effects.

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🌳 Underperformance and Buildup of Risk

#TradFi folks may recall events such as the blow-up of Long-Term Capital Management (LTCM) and the inverse VIX exchange-traded note (ETN) implosion. These mishaps are a byproduct of prolonged suppressed volatility.

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As DOVs gain popularity, the volume of options sold increases. If buy-side demand remain flat, IV would naturally decrease over time, leading to lower volatility. To meet return benchmarks, DOVs would need to aggressively select the strike prices and potentially leverage up.

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A crypto-wide risk-off event will unleash a volatility unwind as short volatility traders will rush for the exits, resulting in a violent positive feedback loop of rising volatility in the markets. This will cause volatility selling strategies to massively underperform.

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Despite the cautionary tales, DOVs have the potential to reshape #DeFi. Looking to get your feet wet in the realm of automated options vaults? New strategies and improved execution are coming your way!

Here’s a timely reminder to always #DYOR before investing.

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Where to start? Here are 6 protocols that offer DOVs! 😊

1. @ribbonfinance
2. @friktion_labs
3. @ThetanutsFi
4. @StakeDAOHQ
5. @Katana_HQ
6. Squeeth by @opyn_

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Read more about DOVs in our latest Insights piece, “DeFi Option Vaults: Democratizing Options” here!👇
treehouse.finance/insights/defi-…

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https://twitter.com/TreehouseFi/status/1539090408398917632