In this guide, we'll explore the world of options - a powerful tool in finance. Whether you're new to investing or a seasoned trader, understanding options can help you maximize profits, minimize risks, and make more informed decisions. We'll break down concepts following real-world examples so you can confidently navigate the options market.

Options trading has a long and colorful history. For thousands of years, people have been using options to speculate on and hedge the value of assets. Even as far back as ancient Greece, the philosopher Thales famously used options contracts to corner the olive harvest, while centuries later, options played a major role in the frenzied speculation of Tulipmania in 17th century Holland. We hope these fascinating historical examples of options will help illustrate what an option is and how options may be utilized in finance to your advantage.

What is an option?

An option is a contract giving you the right, but not the obligation, to buy or sell an asset at a certain price by a certain time. An option contract consists of:

Underlying asset - The asset that is being bought or sold in the future
Strike price - The price you can buy (call option) or sell (put option) the asset at
Expiration date - The deadline by which you must decide to use your option or let it expire worthless
Premium - The cost of the option contract, paid upfront by the buyer to the seller

Options are contracts between a buyer and seller. There are two types: calls and puts.
Calls give the option buyer the right to buy an asset at the strike price before expiration.
Puts give the option buyer the right to sell an asset at the strike price before expiration.

In either case, you pay a premium for this right.

Exercising an option
Exercising an option means actually using your right to buy or sell the underlying asset at the strike price. You only do this if it's financially advantageous for you.

Understanding ITM, ATM, and OTM
We'll avoid explaining more complicated terms like the greeks for now, but understanding these terms gives you a basic idea of an option's potential value:

• In-the-Money (ITM): This refers to an option where the current market price of the underlying asset is already favorable for the option holder. For example, if you have a call option and the market price is higher than the strike price, your option is ITM.
• At-the-Money (ATM): This is when the current market price of the underlying asset is exactly the same as the strike price.
• Out-of-the-Money (OTM): This means the current market price of the underlying asset is unfavorable for the option holder. For example, if you have a call option and the market price is lower than the strike price, your option is OTM.

Remember, these are just the most basic terms of options trading. There is lots more to learn but understanding the basic concepts inside and out will make learning the rest much easier. Let's proceed with some examples.

Thales and his olives

Thales, a Greek philosopher, is considered an early options trader. He predicted a bountiful olive harvest and, anticipating a surge in demand for olive presses, secured the rights to use them at a low upfront cost. This was similar to buying a call option, which grants the right, but not the obligation, to use an asset at a predetermined price (called the strike price) by a certain time (the expiration date). Thales recognized that presses were essential for converting olives into their valuable oil form and could have limited supply during a bountiful harvest. The owners of the olive presses accepted the deal because the fees or premium paid by Thales was guaranteed income ahead of a typically uncertain harvest season.

If presses would be so in demand, why didn't Thales simply buy the presses outright? Thales wanted to conserve his capital and options offered him a limited risk strategy. If his prediction of a bountiful harvest was correct (the option became in-the-money), he could either use the presses himself for a profit or resell his rights to them at a much higher price. However, if the harvest was poor (the option became out-of-the-money), he would only lose the initial, lower upfront cost (the premium), not the full cost of buying the presses outright.

By opting for options, Thales capped his potential loss at the upfront premium he paid for the contracts. However, his potential gains were far greater. He could not only use the presses himself during a bountiful harvest but also profit by selling the options to others. Options provided Thales with a win-win situation, minimizing risk while maximizing his profit potential based on the market's reaction to the olive harvest.

Overall, Thales' story offers a glimpse into the core principles of options trading:

• Risk management: Options can be used to hedge against potential losses. In Thales' case, even if the harvest was poor and his options became out-of-the-money, he only lost the initial premium, not the full cost of the presses.
• Lower upfront cost, high potential upside: Options offer the chance for amplified exposure compared to directly buying an asset at a fixed upfront cost.
• Capitalizing on Market Movements: Options allow speculation on future events. Thales anticipated high demand for an asset at a certain time and used options to potentially profit (in-the-money options) from the anticipated market activity

This understanding can be a stepping stone to exploring more complex options strategies used in modern financial markets.

Tulipmania

In the midst of the Dutch Golden Age of the 17th century, an unlikely asset class captured the public imagination: tulip bulbs. These exotic flowers, recently arrived from the Ottoman Empire, became a status symbol for the booming Dutch middle class. Unlike a painting or a piece of jewelry, however, tulips had a crucial difference: they took years to mature. This time lag, coupled with a particularly rare and desirable virus that created stunning color variations, created a perfect storm for speculation.

The timing of tulips, with their delayed gratification, made options trading particularly enticing. Options contracts allowed people to speculate on the future value of tulip bulbs without ever needing to own the bulbs themselves. This introduced a fascinating dynamic.

Buyer's Perspective: Amplifying Gains with Limited Risk

Imagine a merchant, enthralled by the tulip craze, purchasing an option to buy a specific rare bulb at a set price in a few months. This option contract grants them the right, but not the obligation, to purchase the bulb at the predetermined price on or before the expiry date. This offers a decisive advantage: the buyer's potential losses are limited to the upfront premium paid for the option.

If the tulip market explodes, the option becomes "in-the-money," meaning the market price of the bulb surpasses the predetermined price in the option contract. In this scenario, the buyer can exercise their right to purchase the bulb at the much lower contracted price and then immediately resell it for a significant profit, amplifying their gains considerably.

This "limited risk, high potential reward" dynamic fueled the appeal of options trading during Tulipmania. Even though the market could crash, the option buyer's losses were capped at the premium paid, unlike directly owning the bulb and facing the full brunt of the downturn.

Seller's Perspective: Hedging Risk and Collecting Premiums

On the other side of the deal was the option seller. This could be anyone from the original bulb grower to a wealthy investor, or even someone who didn't own any tulips at all! By selling the option, they agreed to provide the buyer with the right to buy the bulb at a certain price by a certain date. In return, they collected a premium upfront, essentially a fee for taking on the obligation to deliver the bulb if the option was exercised.

Notably, the seller wasn't directly speculating on the future price of tulips themselves. They were essentially hedging against potential losses if the market didn't rise as anticipated. By collecting the premium, they guaranteed themselves some income regardless of the market's direction. If the market remained stable or even dipped (the option became "out-of-the-money"), the seller would keep the premium as pure profit without ever needing to deliver a bulb. This scenario offered a way to hedge against market fluctuations.

However, if the tulip market exploded, the option would become "in-the-money," forcing the seller to sell the bulb at the predetermined price, potentially much lower than the market value, and potentially incurring a loss.

Options offer benefits to both buyers and sellers

Options, even in a downturn, can offer a measure of risk mitigation compared to directly owning the underlying asset. This is because they provide both buyers and sellers with distinct advantages: Buyers can limit their potential losses while potentially amplifying gains, while sellers can secure a guaranteed premium regardless of the market's direction. This "win-win" dynamic, where both sides benefit from the inherent characteristics of options contracts, fueled their widespread adoption during Tulipmania. While the bubble eventually burst, it serves as a historical case study demonstrating how options, even in volatile markets, can offer a level of risk management compared to directly owning the underlying asset.

Why options matter in finance and DeFi

Robust options markets are a hallmark of a mature financial system. They empower traders with tools to manage risk, speculate on price movements, contribute to price discovery, and ultimately help establish the fair value of the underlying assets. This fosters liquidity and broader market participation.

The widespread adoption of options trading in DeFi marks a significant step forward. It equips market participants with the tools they need to navigate the inherent volatility of this nascent market, allowing them to hedge risks and potentially generate additional returns. This signifies a crucial step towards building a more robust and efficient DeFi ecosystem.

Conclusion

TLDR: Options markets are a sign of a mature financial system, offering risk management, speculation, and price discovery tools. Their emergence in DeFi signifies a crucial step towards building a more robust and efficient ecosystem.

While the potential of on-chain options trading is undeniable, current inefficiencies hinder its widespread adoption. Scholes Protocol is actively addressing these challenges by designing a seamless and intuitive trading experience. One of our top priorities is to build a user-friendly UI/UX, complete with clear visualizations and streamlined workflows. We want to make options trading accessible and understandable for both beginners and experienced traders, ultimately contributing to the growth and maturity of the entire DeFi ecosystem.

Check out part 2 of our Intro to Options series to learn about more about options.

Scholes Protocol aims to be the go-to platform for navigating the exciting world of on-chain options trading. Join the Scholes community to be the first to hear updates when our public testnet is going live!

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