#3 | The problem with NFT options
and a review of the NFT options landscape
The NFT market is maturing…
The NFT spot market has matured substantially over the past year, bringing innovation in a few adjacent verticals still looking for product-market fit. Some of these improve NFT liquidity through an NFT AMM (Sudoswap) or NFT fractionalisation (Unicly), while others unlock NFT credit markets through peer-to-peer lending (NFTfi, Arcade) and peer-to-pool lending (BendDAO, jPEG’d).
The logical next step to build out the “NFTfi ecosystem” is likely NFT derivatives (options, perps). The bear market is also a particularly interesting time to build these to capture demand for shorting NFT collections which have soared to insane prices during the irrational exuberance of the bull market.
In short, buying an NFT call option lets you (a trader) “long” an NFT, i.e. make a speculative bet that its price will increase, during a specific window of time. Selling an NFT call option lets you (an NFT holder) earn premium on your NFTs and/or sell them at a favourable price. Vice versa for put options.
However, building an NFT options marketplace comes with its own unique set of challenges.
The problem with NFT options
Existing NFT protocols are really struggling to gain any reasonable traction. Here are 5 challenges every protocol will need to figure out to become successful.
Even NFT spot liquidity is too thin. Protocols will need to have good visibility on liquidity at target option expiry dates, yet even blue chip NFT collections such as Bored Apes have only 5-10 trades per day (as a comparison, there hasn’t been much success in financial derivatives for traditional art or collectibles, so I think gaming NFTs with higher trade volumes might be a better fit). There’s an even bigger problem if liquidity dries up completely (i.e., there not a single buy/sell order on the orderbook) at the date of the contract’s expiry. To increase this liquidity, you either need to be creative or you will need traditional market makers to come in, which brings me to the next problem.
You need NFT perps for NFT options to thrive, and vice versa. If you want to be market-neutral and are long on call options, you want to hedge your position through either (i) short spot, (ii) short perps, (iii) short calls on a different platform. Option (i) isn’t capital efficient and for option (iii), there aren’t any mature NFT options platforms out there yet. The current best hedge is to short perps, but you can’t do that effectively now. The reverse is the same if you’re long perps and need to run a market-neutral trade. Ultimately, you need both perps and options to attract market makers and run an efficient derivatives market with deep liquidity. And at its current state, NFT perp models are based off vAMMs which could potentially be inefficient, leading to large slippage.
Pricing NFT options is not as easy as punching some numbers into the Black-Scholes formula. Black-Scholes is not really applicable in the context of NFT collection floor prices as (i) you cannot replicate a hedging strategy (which Black-Scholes relies on), (ii) it was designed for European options and while it could still work for American calls, it doesn’t work for American puts, and (iii) there is no confirmation that floor prices behave as geometric Brownian motion. One way you could circumvent this is by doing what Hook Protocol does: merely ‘suggesting’ an options premium price and allowing the option seller to ‘adjust’ it based on his/her risk appetite. However, this is just passing on the problem to someone else (i.e. a degen or a market maker). A potential solution is for early movers to refine their pricing strategy by collecting options trading data (the exact methodology is left to the user as an exercise).
Striking a good trade-off between option customisability and liquidity is difficult. Allowing all types of customisations (options premium, expiration date, NFT collection, etc.) will fracture liquidity and render your marketplace a desert. Market makers and sophisticated traders/hedgers will prefer customisability, but given the rise of degen options traders driven by the memefication of options by Robinhood, you will likely need to cater to retail users who might prefer a simpler catalogue of options.
Building the right UX is difficult (whether positioning it for traders or speculators). It is interesting to see players in the scene going different routes: Putty/Cally Finance going to the cypherpunk/Curve simplistic UI, BullvBear going the gaming UI route, and Hook Protocol going the clean web2 route. I think ultimately it depends on your product positioning and as long as you’re able to play to your strength to achieve virality on Twitter and gain traction, you’ll be fine. Right now it’s anyone’s game.
Deribit was founded in 2016 but only really gained traction in 2020 when BTC and ETH option volumes skyrocketed after they built a strong liquidity moat. It took ~4 years after crypto went “mainstream” for them to become successful, so NFT options protocols will need to maintain sufficient cash to stay alive and brave out the “crypto winter” or find creative ways to gain revenues in the meantime.
We are seeing many bright teams (see next section) building “NFTfi”, whether it’s NFT options, perps, liquidity or market-making protocols. If you’re building something interesting or want to discuss ideas, my DMs are open.
NFT Options Landscape: The Race is On
There are 4 live platforms as now (Oct 2022) and at least 4 under development.
Founded by Jake Nyquist in 2019 as a platform to exhibit and sell fine art online, Hook raised ~$1M from Slow Ventures and Contrary Capital. I really like the simple and clean UI with clear descriptions targeting retail traders, e.g. “I think that CryptoPunks will go up by Fri Oct 28” instead of “buy call CryptoPunk call options”. There is limited traction after launch (15 options in 2 months), although they did get covered by Bankless.
Putty (and Cally) were started in April 2022 by out.eth and 0xtamagoyaki. They were funded by Maven11 earlier this year. Putty is a P2P NFT (and token) options marketplace which allows users to create “buy” & “sell” limit orders for both put AND call (lol yes) options. It optimises for having a high degree of customisability (e.g. any token/NFT, single/basket, strike, premium, tx currency, expiry) with the trade-off of increased liquidity fragmentation (i.e. there will be a put option for “CryptoPunk #3388 at 50.6 ETH and 2.1 ETH premium expiring in 30 days” looking for a buyer). This is going to be catered towards sophisticated traders, hence the cypherpunk / Curve UI.
Traction is limited so far with only 9 open puts. Their Dune dashboard shows they have matched 80 orders with $200K notional volumes in the first month, collecting ~$10K in premiums. However, volumes mostly came from a few spikes in September, while recent volumes are down significantly.
Cally was founded by the same team above. It offers covered call vaults for NFTs and tokens. Essentially, users can sell covered calls by opening Cally vaults with their own NFTs to earn yield. Interestingly, they use a dutch auction to determine a strike price (i.e. it is variable), so once you list your NFT and set parameters for your vault, the 24h auction begins where the strike price slowly moves down until an option buyer decides that the strike is low enough to justify buying the option.
Traction is also limited with 2 call vaults on Ethereum and 6 on Optimism. The listed NFT/tokens aren’t mainstream ones. Given they’re founded by the same team, I’m unsure why the team has split their audience into 2 twitter accounts.
The first NFT options protocol on Ethereum. It’s a very simple platform where you can buy and sell put options with high customisability (e.g. premium, strike, expiration). Traction is almost non-existent given how long it’s been live, with 4 unfilled options, 7 purchased options and 7 closed options (mostly random NFTs, no blue chips). Also doesn’t seem to be doing much on Medium since Oct 2021 and has almost zero engagement on Twitter.
Bull v Bear recently got out of stealth (Sep 2022). Not much info is public yet, but I particularly enjoy the gamified retro art style to attract the degen trading crowd. They’re building a community through hosting fantasy trading competitions and calling out rekt traders… marketing guy clearly doing his homework on how to get viral. The founders are very experienced in tradfi options, and they also have a solid lineup of influencers backing them which will be a great megaphone to attract retail volumes. Definitely something you should keep an eye on.
Fuku is a decentralised NFT options protocol disguised as “buy now pay later” for NFTs. NFT owners can sell call options on their NFT to earn premiums (the “cost” of BNPL) while prospective buyers (BNPL customers) pay the premium up-front to buy the call option and lock in a future purchase price. The BNPL service is completed when the prospective buyer exercises the option. Their protocol is still under development, but docs are already available here.
JpeX was founded by Aditya Pandey and Agar Pranjal who built the MVP during the EthGlobal Hackathon in May 2022. The UI gives me strong Gem.xyz vibes. The founders are strong shippers, so you should definitely keep an eye out on Twitter for announcements.
Not much is known here but they did reply to my question on Twitter. The platform allows you to buy and sell covered calls and WETH-secured puts. UI seems pretty cool.
Bonus: NF3, a multichain NFT P2P bartering, swap, loans & options platform but not much else is known - they launched their Twitter in Sep 2022 and seem to have raised a ~$1.6m seed.
Needless to say, I’m excited to re-visit this space in a year and see which protocols will be able to gain sufficient traction.
Disclaimer: This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the author(s) and does not necessarily reflect the opinions of Tioga Capital. The opinions reflected herein are subject to change without being updated.