Introduction

We have been getting questions on how GammaSwap V2 works and how it differs from vanilla options. In this article, we will walk through the how options compare to other leverage instruments and how prediction markets are a type of option.

Vanilla Options vs Perps

The most basic and popular form of options trading is buying calls and puts. A call offers a substantial return if the underlying asset is above the price you choose to buy at, the strike price. A put offers a substantial return if the underlying asset is below the strike price.

Buying calls and puts provide leverage but they differ from perpetual futures in a few key ways. With calls/puts, the more right you are the more you get paid. With a perpetual future, the return is linear and a multiple of spot exposure.

Also, unlike perp futures, there are no liquidations when buying calls or puts. As long as you are right by the expiration date you choose. With a perp, if the value of BTC decreases 20% then increases 100%, even with modest leverage you will lose your whole position. This is called path dependence and it is not a risk when trading options.

Call & Put Spreads

You can also combine options to reduce or change your risk exposure, such as straddles, strangles and spreads.

A call spread is an options trading strategy where you buy one call option and simultaneously sell another call option on the same asset and expiration but at a higher strike price. A put spread is the opposite.

Trading spreads lowers your upfront cost, time decay and reduces your maximum risk, but it also caps your potential profit.

Prediction Markets = Call & Put Spreads

Prediction markets replicate the payoff of call and put spreads but instead of using separate strike prices, it is the same strike price with the contract value bounded between 0 and 1.

Here are the advantages of this approach:

• The price is the probability of the outcome, making it easy for retail to understand.
• Since up is a call spread and down is a put spread, it is easier for MMs to underwrite this risk than typical options where the risk is unbounded. This is particularly useful for providing liquidity into exotic and long tail markets.
• Settlement is based on a cash amount agreed upon upfront, 1$ for every contract. The known payout provides certainty for retail and makes it easier to implement into automated strategies.

In Conclusion

A prediction market is an option spread with a single strike price. It works well when supporting short durations and exotic assets since the risk is bounded. It also retains many of the benefits of options with a friendly UX, each price is the probability of the outcome.