Options are a financial primitive from which one can build many different more complex financial instruments. At their core, options give a trader the choice to buy or sell an asset at a predetermined price at a known time in the future. This is useful for protecting one's self (also known as hedging) against possible price changes in the asset, as well as speculating on these price changes.
Core Protocol Mechanics
SIREN uses a fully-collateralized approach to writing options that doesn’t require any oracles to function. A single MarketsRegistry contract creates and coordinates individual markets. Once a Market contract is created anyone can interact with it in a permissionless manner. The solvency of a position is ensured at all times by the collateral locked in the smart contract.
With SIREN, both the long and short side of the contract are tokenized. The buyer’s side (bToken) gives the holder the right to purchase or sell the underlying asset at a predetermined strike priceThe seller’s/writer’s side (wToken) allows the holder to withdraw the collateral (if the option was not exercised) or withdraw the exercise payment (if the option was exercised) from the contract after expiration.
When a trader buys a put the on-chain token amount is multiplied by the strike. For example, a 1 WBTC $20K PUT will result in 20,000 bTokens. For the same reason, a put is just a reversed-assets call (e.g. a WBTC/USDC put is actually a USDC/WBTC call).
Tokenizing both sides of the contract allows SIREN to create secondary markets for both the long and short exposure. Under such a design in order to become a writer one purchases a wToken from the SirenSwap AMM (see below). A writer can also unwind their short exposure by selling the wToken back to the AMM. This streamlines the write-side mechanics by reducing it to essentially purchasing the underlying collateral at discount — as opposed to a typical design where the writer mints long tokens and has to then sell them in order to realize the premium.
Bootstrapping liquidity is core to creating a thriving market. Options are notoriously difficult when it comes to that. Not only does liquidity get fractured by combination of strike prices and expirations, it also requires sophistication on the part of liquidity providers in order to ensure fair and sustainable pricing.
To ensure liquidity on day 1 the SIREN protocol utilizes a custom SirenSwap AMM that uses a novel combination of a constant-product bonding curve and options minting to trade both bTokens and wTokens. Notably, the AMM doesn’t require any asset in the pool other than bTokens/wTokens in order to trade them against the collateral asset (e.g. WBTC). This increases LP capital efficiency and provides other benefits that we’ll expand on in further posts.
The SIREN core team believes that in these early days of Ethereum and DeFi less is more, so they designed SirenSwap to be a model-less market maker. This means there is no complex on-chain pricing formula nor oracle feed required in order for it to function. This makes it easy for anyone to become an LP to potentially earn trading fees."
Upgrades launching this month for Siren, the DeFi Options Protocol
Illustration by Christine Foltzer
Siren Lemuria, the latest version of the Siren DeFi options trading protocol, will be released this month. In advance of launch we are sharing a two-part series of deep-dive articles on the technical improvements coming with Siren. See the Lemuria launch announcement for a high-level overview of the major protocol improvements.
Upgrading Lyonesse to Lemuria
Siren Lemuria replaces the previous protocol version, Siren Lyonesse. Lyonesse launched in August 2021 and was already a significant improvement over the first version of Siren, which was launched on Ethereum Mainnet in March 2021.
One of the major improvements in Lyonesse was the move to Polygon, which allowed the protocol to execute more computation on chain due to Polygon’s faster execution time and lower gas fees.
The release of Siren Lemuria builds on the groundwork laid by the previous version to significantly improve the Siren protocol for all our users. In this post, we will examine some of the upgrades in Lemuria that particularly benefit options traders. Our subsequent post will examine upgrades that benefit liquidity providers.
Better Options Prices
One of the most significant upgrades in Lemuria is to how the Automated Market Maker (AMM) calculates prices. The previous Siren AMM used a popular Black-Scholes approximation that matches the full Black-Scholes pricing model fairly well at-the-money. However, under the approximation model in- and out-of-the money options were often overpriced, sometimes by 10x and more.
This limitation of the Black-Scholes approximation created several negative consequences:
First, Out-of-the-Money (OTM) options were highly overpriced. This expensive pricing made these options unattractive versus options that could be purchased on centralized platforms such as Deribit. Second, At-the-Money (ATM) options were underpriced compared to In-the-Money (ITM) options.
These discrepancies led to enhanced returns from “scalping” the AMM — i.e. buying during price dips and selling quickly after if the underlying asset price went up. Meanwhile, if the underlying asset price went down, overpriced OTM options protected trader’s losses, because the AMM will always buy back options sold to it by traders.
In other words, on previous versions of Siren buying ATM options and selling them back used to pay too much money without enough risk, i.e. carried a higher expected return that it should have, when compared to a fairly-priced options curve.
In Lemuria, these issues are mitigated by using a full Black-Scholes model instead of an approximation. Implementing the full on-chain model required significant engineering lift which took many months to perfect, and we’re very proud of all the work of our engineering contributors.
Previously, traders that wanted to buy DeFi options using Siren were putting their desire to trade decentralized contracts or unusual assets over their desire for a strictly competitive price. With the changes released in Lemuria, Siren will now be attractive to traders not only on an asset or a decentralized basis, but also on price.
A Sophisticated Volatility Oracle for Greater Decentralization
The Black-Scholes pricing calculation relies on a measure of Implied Volatility (IV) in order to effectively price options. The previous version used an IV parameter that was set manually using an off-chain oracle. Using a centralized source for such a critical piece of the Siren infrastructure was a long-term security risk and also significantly raised operational overhead. Also, an infrequent update schedule led to delayed pricing that didn’t respond to real-time changes in market volatility.
The measure of IV used in Lemuria is sourced fully on-chain via the VolatilityOracle contract. Using an on-chain oracle allows protocol options pricing to respond to market volatility in real time, which improves pricing for traders, and brings Siren ever closer to achieving a fully-decentralized, highly-scalable protocol that can function like the Uniswap of crypto options.
Auto Series Creation for Abundant Trading
Siren is constantly cycling through options contracts as existing options expire and need to be replaced. As a decentralized product, Siren creates options using on-chain smart contracts, which means new smart contracts need to be continuously deployed for traders to be able to buy new series.
In previous versions of Siren, many options contracts were deployed manually by Siren contributors every single week. This implementation created significant operational overhead — every time Siren added a new asset, an ongoing set of tasks needed to be performed to maintain series for it. The human bottleneck limited how many series we could offer, assets we could list, and chains on which we could launch.
This limitation prevented traders from selecting the precise expiration date or exercise price series they wanted to trade, since they could only trade what was manually added, and as the underlying price of an asset moved during the term of a contract, contributors needed to manually add more relevant strikes to keep up with the price.
In the new release of Siren Lemuria, series will be created on the fly. If a trader wishes to buy an option series which wasn’t yet added to the protocol, it will be added automatically. Traders will now have a plethora of series available to trade at any time, and Siren will no longer be operationally constrained in the number of assets on which options are offered.
With the auto-creation feature, Siren is approaching the day in which the protocol becomes truly permissionless and options markets for new assets will be added by anyone, on any compatible chain.
The new protocol release not only has a lot for traders to be excited about but also has benefits for LPs, so stay tuned for Part 2 of this series on upgrades coming to Siren Lemuria!