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Undercollateralization
DeFi Options platforms typically require traders to fully or over-collateralize their positions creating an inefficient capital system restricting traders and trading activity.

Overview

Zeta will utilise the following core mechanisms to enable under-collateralized options trading:
  • Portfolio Margining System Locks up collateral while being aware of existing risk profiles.
  • Liquidation Engine Oversees trading positions and ensures that sufficient levels of collateral are maintained to service their open positions (taking into account their current PnL).
In the following sections we go over why these components are essential to a successful options trading protocol.

Collateralization

Portfolio margining is a complex problem, as selling naked options may present unlimited risk. When placing an order, Zeta will take into account both:
  • Upfront collateral requirements based on the option being traded.
  • Collateral concessions based on whether they hold existing positions of options structures that sufficiently hedge their risk β€” thus allowing them to be undercollateralized.

Upfront Collateral

Upfront collateral needs to be posted based on the option being purchased. When buying an option, the premium paid for the option itself covers the risk β€” meaning that you can never lose more than what you paid for the option. This is why options are considered useful as a means of fixed-price insurance against severe market swings.
An example of a long put β€” the fixed price component is reflected in the premium.
On the other hand, when selling options, one can end up being exposed to theoretically unlimited risk. For example if one sells a SOL call option then they give the buyer the right to purchase SOL at that initial price. The more SOL increases in price, the more the call seller has to lose with there being no upper bound to the price in theory.
As a result, we must protect ourselves from potentially large losses by requiring users to front some initial collateral, calculated as follows.

Collateral Denomination

All collateral will be denominated in stablecoins within our global vault, with plans to potentially expand to a multi-asset collateral system in future.
Initial Option Margining
Margin is determined based on the Mark price of the option. This will be determined as the mark price plus a percentage of the spot (which scales proportionally with how OTM the option is). This can be formulated as follows:
Vmark+max⁑(ΞΊMspot,Mspot(1βˆ’Ο„Sβˆ’KS))V_{mark} + \max(\kappa M_{spot}, M_{spot} (1-\tau \frac{S-K}{S}))
Where
ΞΊ\kappa
and
Ο„\tau
are variables based on the liquidity of the orderbook and volatility of the underlying assets.
VmarkV_{mark}
is the mark price of the option and
MspotM_{spot}
is the spot margin amount.

Collateral Concessions

Zeta will be able to recognise the combination of options that Traders hold and thus be able to effectively determine where margin requirements increase or cancel out due to new positions. Effectively setting margin requirements to the Max Loss that a Trader is exposed to.
Portfolio considerations such as the following would be made:
Option Structure*
Margin Consideration
Covered Call
Only margin for the spot is required
Covered Put
Only margin for the spot is required
Debit Spread
No margin is required.
Credit Spread
Margin required is the difference between the two strikes.
Short Straddle
Margin required is the regular standalone margin on the higher priced option + the mark price on the lower priced option
Short Strangle
Margin required is the regular standalone margin on the higher priced option + the mark price on the lower priced option
* See Terminology for explanations
Collateral is managed on a portfolio level, allowing it to be consolidated across all strikes for a given underlying and expiry. This will enable users to use their capital more efficiently and build more complex positions, as they are no longer restricting their collateral to a singular option, and can be rewarded for hedging their risk.
When a user wishes to enter a trade, Zeta will query their locked collateral to ensure that sufficient collateral is available to enter a trade. As more positions are entered Zeta will identify the trader's existing positions and where collateral requirements will either increase or cancel out, allowing requirements to be updated accordingly. As positions are traded and settled, profit and loss (PnL) will be assigned to their collateral holdings in the vault. The Trader can then withdraw their available collateral.

Liquidation

Zeta will use a liquidation engine to secure the trading network against at-risk positions in order to minimise impact on market participants.
The liquidation engine will be used to identify positions that move below their maintenance margin. At this point, market participants can choose to take over these positions as a liquidator in exchange for a spread charged by the liquidator. As a fallback, the OMM will always present a bid and ask and thus be able to take over underwater positions for a similar spread.
Example A trader goes short a call option with a mark price of $100, a liquidation price of $120 and a bankruptcy price of $125. The trader is liquidated when the mark price reaches the liquidation price ($120). The trader is forced to buy back the option at a premium, which is the bankruptcy price ($125) from the liquidator. The liquidator at this stage is short the option at $125. The liquidator can then buy back the option at the mark price ($120). If the order is filled at $120, then the liquidator has effectively sold the call option at $125 and bought it back at $120, generating a $5 premium.

Insurance Fund

Zeta will also have an insurance fund to cover events of mass liquidations. This will be funded from the platform's trading fees.
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