KAKI’s WMM-DDH: Writer Market Making-Delta Dynamic Hedge Model Explained
KAKI’s options products are divided into two sections. The first part is entertaining options, which are simple and fun, suitable for users who want to experience game options. The second part is retail options, which is more biased towards professional options players and aims to provide a unique options trading experience. I’m sure that you are already aware of the entertainment options part, which we’ve covered in previous articles and would not go into details here. The main point of this article is to unveil the true nature of the second part of the product and see what a mysterious beauty is under the veil.
The products currently under development in the retail options section are European-style options, that is options that the buyer must exercise on the expiration date. However, users do not need to worry about the exercise date, because KAKI’s European-style options have developed a new liquidity pool model, which is a WMM-DDH model, integrating option market making and secondary market — -Writer Market Making & Delta Dynamic Hedge.
The figure below is a basic architecture of the WMM-DDH model:
The special feature of the WMM-DDH model is the liquidity solution, which has several noteworthy highlights, let’s take a closer look at it.
Firstly, the endogenous quoting mechanism to avoid oracle risk.
The DDH model introduces an independent AMM mechanism to generate stable and reliable spot prices for options automatically, which could effectively reduce the price of options and provide traders with arbitrage and hedging opportunities. Although AMM cannot guarantee risk-free, portfolio asset conservation is possible to achieve.
Oracle price feeding is a high-cost choice because the quality of the price data cannot be guaranteed, and more importantly, there are security vulnerabilities to be attacked. Considering that fact, KAKI ruled out the oracle method in favor of AMM.
Contrast this with the simplified pricing model used by Hegic, whose implied volatility needs to be updated manually based on information from Skew.com, plus each option charges a 1% fee, shared equally by LPs, so the option price is relatively high on Hegic. In particular, there is no slippage in option pricing, and it is difficult to maintain a balance between the call and put from the option pool, making it difficult for LPs to hedge risk. The LPs also have to take the bet losses.
Secondly, market makers are nearly risk-free.
As market makers, the risk exposures of LPs are shown in the following chart: direction, time, volatility, and interest rate.
As the sellers in the option, market makers have to take the risks above accordingly. Among the four dimensions above, time value and interest rates are friendly to the sellers. LPs deposit assets in the liquidity pool and the basic returns come from interest rates. It helps to understand it if you think of the returns of LPs on lending platforms like Compound and AAVE. This is one of the sources of earnings of market makers.
Another source of earnings is coming from the time value of an option. Here we need to understand the five Greeks that affect option pricing: Delta, Vega, Theta, Gamma, and RHO. They are the main risk measures of option value which represent the sensitivity of options in spot prices, implied volatility, time decay, as well as the changes of interest rates. As exercise time approaches, the value of an option is gradually decreasing, which is a disadvantage for the buyer but a benefit for the seller. So that Theta, which indicates the time decay, is the second dimension of the option seller’s return.
After removing two positive factors, we have two disadvantages left, namely direction and volatility, which are correspondingly represented in the Greeks by Delta and Vega. Therefore, the main challenge solved by WMM-DDH is to hedge the risk of Delta and Vega instantly. Let’s take a look at the figure below:
The DDH calculates Delta and Vega for each option contract in the pool every once a certain time, and trades spots from the S Pool to hedge Delta and Vega in order to keep them at zero, so that market makers do not need to worry about these risk exposures. It can be said that WMM-DDH can achieve stable and positive returns for market makers under normal conditions. In addition, our developers have conducted an extensive risk assessment on WMM-DDH, and we found this design is fully feasible.
Compare with other DeFi option protocols’ liquidity pools such as Hegic, FinNexus, Charm, etc., there are still risks exposed to market makers. Although it was designed as a peer-to-pool mechanism, it only weakens a small part of the risk, the potential of loss still exists. It is worth mentioning that Charm’s liquidity solution uses AMM to create liquidity, and generates different option vouchers through a bond curve, and expresses the risk coefficient of each option through a variable function. Both buyers and sellers could clearly know the risk exposure of their positions, which facilitates arbitrage or risk hedging on different platforms. However, the defect still exists. Because Charm’s single liquidity pool is too scattered, the liquidity of different underlying assets cannot be shared, which would largely limit the efficiency of funds. At this point, the buyers and sellers of KAKI’s DDH pool trade through stable coins, which is more conducive to the buying and selling of retail options, so it brings the fund pool greater potential. The stable income of the market maker would effectively stimulate the expansion of the capital pool, thereby further promoting the improvement of liquidity and forming a long-term virtuous circle of the capital pool.
Thirdly, WMM-DDH integrates the secondary market of option repurchase in one.
For options trading, the secondary market is a very important component, which is also in a mutually reinforcing and inversely symbiotic relationship with the liquidity pool. The boom in the secondary market can greatly prosper the liquidity pool. However, most of the DeFi option protocols in the market, like Hegic and FiNexus, cannot repurchase options.
The WMM-DDH model of KAKI that integrates market making and secondary market, allows traders to sell the option at any time before it expires. The repurchase price of the option is automatically generated by the WMM-DDH pool, and of course, with the market maker’s position hedged out, the market maker does not need to worry about losing money.
In summary, KAKI’s WMM-DDH model is a whole new liquidity solution. It uses a dynamic hedging mechanism to solve the market maker’s risk problem, creating a stable investment platform for market makers. On this basis, the WMM-DDH model can provide these services as follows:
🍊 Selling spot
🍊 Buying specified option contracts
🍊 Repurchasing option contracts
🍊 Early execution options contracts
🍊 Exercising option contracts at the expiry date
🍊 Option perpetuation services
KAKI, we redefine options!