The Structured Products of Friktion

Friktion’s first volt is designed to generate income, and it involves writing covered calls on the user's ETH, BTC, SOL, or MNGO. To understand how the strategy works, I should explain what a call option is. A call is a derivatives contract which gives the buyer the right, but not the obligation, to buy an asset at a fixed strike price prior to the expiration date. If the price of the underlying asset goes up, the buyer can exercise the option, buy the underlying asset at the lower price, and then sell it at a profit at the current, higher price.

In exchange for this option, the seller collects the purchase price of the contract, which is also referred as the option's premium. As long as the price of the underlying does not go above the strike price, the seller will keep the premium and not have to sell their asset.

An example will hopefully make things clearer.

Say you sell a BTC call option with a strike price of $30,000 and with an expiration date of 30th September 2022 for $100. If before the expiration date of the contract, Bitcoin price ends below $30,000, the option will not be exercised and you keep the $100 at no cost. On the other hand, if BTC rises above $30,000 – say $32,000 – before the maturity date, you will sell your BC at $30,000 and miss out on the $2,000 of profit.

Now, how can you trade this strategy on Friktion? Let’s say you have 1 SOL. During a bear market you want to put your asset to use to generate yield on your Solana. SOL price is $42 right now. You sell $48 call option for $5, and pocket the premium. As long as the price keeps going down, you will not have to sell your SOL.

Volt #2 runs an automated cash secured put strategy. A trader sells an out of the money (OTM) put option on the underlying asset, but he also has to hold enough cash to buy the underlying asset if the asset price falls to the strike price and the option is exercised. You collect premium from the buyer of the option for selling him the right to sell the underlying asset to you at the price set in advance.

This Volt (actually, all Volts on Friktion at the moment) are cash-settled, which means that your funds will not actually be employed to buy back the underlying. As of this writing, Friktion supports BTC, ETH, SOL, and MNGO as underlying assets; the stablecoins supported by the protocol (the cash you should hold) are USDC, PAI, and UXD.

By selling a put you’re betting on the asset price not to dip below the strike price. Therefore, this strategy works in bull markets but can experience big losses in violent downward moves. Like all trading strategies shorting volatility, cash-covered put selling also exhibits negative skewness. It means that you can expect frequent small gains and occasional large losses. Below I paste just a part of Volt’s historical performance to show you that this is the case.

This strategy is more complex than the two mentioned above. Since it isn’t a directional bet on the price move, it performs best in sideways markets. The strategy collects premia by shorting volatility, and it does that by shorting Power Perpetuals while hedging price risk with normal perpetuals. For the last sentence to make sense, we should understand funding rates, (ordinary) perpetuals, and power perpetuals. Perpetual futures are like traditional futures with one important difference: they don’t have an expiration date. You can hold your position without thinking about maturity date and delivery. However, in order for perpetuals to never expire, they must have a mechanism to ensure that perpetuals prices won’t diverge from the prices of underlying assets. This is where funding rate enters the play. Funding rate helps perpetual price to converge with the price of the underlying asset.

The prices of a perpetual contract and the underlying asset are called mark and index, respectively. If the perpetual is trading at a premium to the index (i.e., perpetual price is higher than the underlying asset price), to hold the perpetual is better than to hold the coin itself. That’s why longs will pay short an amount that corresponds to the divergence of the mark from the index. This is also called a positive funding rate. Conversely, a negative funding rate is something that shorts owe longs. This happens when the mark is trading lower than the index.

Let’s say ETH price is $1,700 while ETH-PERP is trading at $1,710. The perpetual is trading at a discount to the index, which means that there is a positive funding rate of 0.59%.

$(1710-1700) / 1700 = 0.0059$

If the divergence of the mark from the index price lasts too long, the arbitrageurs can exploit it by taking opposite positions in the perpetual and the underlying asset. In this example, a trader could short ETH-PERP and buy ETH. The sell pressure on the overvalued (expensive) asset and the buy pressure on the undervalued (cheap) asset will cause the prices to converge. Thus, the trader will earn the funding rate on the (almost) risk-free trade.

Funding rates are determined by the market. If traders are more inclined to be leveraged on the long side, then there will be a demand for buying the perpetual contract. This implies that the mark (perpetual’s price) will trade at a premium to the index (the underlying asset price), which causes the funding rate to be positive. Conversely, the demand to be leveraged short will cause the perpetual to trade at a discount to the underlying asset. Thus, the funding rate will be negative.

Now that we understand funding rates and normal perpetuals, let’s take a look at power perpetuals. Power perpetuals track the price of the underlying asset raised to a power. For example, SOL2 simply is the power perpetual whose underlying is SOL price squared.

The main reason to trade power perpetuals instead of ordinary perpetuals is that they exhibit option-like characteristics. Mathematics will make this clear. The value of the normal assets can be written as (1+r), where r is the return in percent. However, the squared return of a power perpetual will be:

$(1+r)2 = r2 + 2r +1$.

You can think of the power-2 perpetual as a 2X levered normal perpetual because of this 2r.

Let’s look at concrete numbers to fully understand the concept. Say you purchased $1,000 of SOL. If price goes up 10%, it will be worth:

$1,000 * (1 + .10) = 1,100$.

If you hold a normal perpetual, SOL-PERP, your return will unsurprisingly be 10%.

However, if you would’ve bought Power-2 Perp on SOL, your gain would be:

$(1+.10)2 – 1$ = 21%.

On the other hand, if SOL price falls by 10%, the value of the power perpetual will be:

$(1-.10)2 – 1$ = -19%.

So, when SOL price goes up by 10%, your gain is 21%; but if the price decreases at the same rate, you lose not 21% but 19%. This is what we mean by the “option-like characteristics” of power perpetuals. If power is greater than 1, longs get an asymmetric upside which increases the r/r for going long the power perpetual. That’s why the power-2 perpetuals almost always will trade at a premium to the underlying asset price squared (e.g., BTC2 perpetual mark price will be higher than the index price of BTC2). And this means that power perpetuals with the power > 1 will almost always have a positive funding rate.

Power-2 perpetuals (or all perpetuals with the power > 1 for that matter) should trade at a premium to the index price. Why? Because if you could buy SOL2-PERP at the index price and then short SOL 2X (levered SOL), your return would be:

$(1+r)2 – (1+2r) = 1 + 2r + r2 – 2r – 1 = r2$

We know that r2 is always positive if r > 0 so there’s an arbitrage opportunity in holding SOL2-PERP and shorting SOL 2X. That’s why the power perpetual will practically always trade higher than the index price. And this in turn means that SOL2-PERP will have a positive funding rate as already mentioned above. We know that a positive funding rate translates into longs paying funding shorts to get the convex payoff of the power perpetual. Shorts receive premia by shorting volatility and taking the risk of asymmetric payoff against them.

That’s the idea behind Volt#3. Since power perpetuals have a positive funding rate, it makes sense to short them. In order to hedge the price risk, the strategy goes long the normal perpetuals.

This strategy is also based on collecting the funding rate, though it is a bit simpler. It enters the long perpetual position when the funding rate is negative. Recall that when the funding rate is negative, it is the longs who receive the funding. Therefore, the Volt enters a long position in SOL-PERP to collect the premia. But since SOL price can crash, the Volt must hedge this risk. It does so by shorting the SOL thus achieving a delta-neutral position. The strategy becomes a “direction-agnostic” bet gaining the funding rate in a negative rate environment.

Note that in a positive funding rate environment the strategy won’t work. However, as the documentation says, if the positive rates are persistent in the market, the Volt will exit the long perpetual position until the rates revert to the sub-zero region. Another risk is abnormal volatility, which can liquidate one of the legs of this delta-neutral strategy.

Friktion Volts are passive income strategies designed to earn yield through various market cycles. They can be used to generate profit in bullish or bearish, volatile or range-bound markets. The first two Volts involve selling options to harvest premia; the other two Volts collect funding rates. These strategies can provide a great return, but do consider the associated risks. There are market risks, circumstances under which these Volts won’t work, and smart contract risks, which almost all DeFi protocols have. With all of this said, Friktion provides a nice collection of structured products and should be considered as a means of using DeFi to achieve passive income.