Hedging Process

To neutralize the volatility of its collateral, Otto aims to maintain a delta-neutral portfolio, which means being insensitive to collateral price movements. However, holding collateral gives an implicit long position on it, making it challenging to achieve delta-neutrality by opening a short futures position due to the funding rate.

The funding rate is a tax imposed on long or short traders and paid to traders who do not pay it to correct the difference between the price of futures contracts and spot contracts. Due to the unpredictable nature of the funding rate, Otto cannot take short positions in futures contracts to achieve full market neutrality.

Instead, Otto uses options to hedge the volatility of the users' collateral. Options are financial derivatives that give the right to buy (call option) or sell (put option) a certain quantity of an underlying asset at a certain date and at a pre-agreed price (the strike price). A premium is paid to acquire this right.

Otto uses them to create synthetic short positions in futures contracts. A synthetic short futures contract uses long puts and short calls with the same strike price and expiration date to simulate a traditional short futures contract, which is not exposed to the funding rate. However, options have a time-bound nature, and replacing the collateral at each expiration would require paying fees again, which is not sustainable. In addition, almost all vanilla options traded do not have customised strike prices and sizes, which means that users would have to pay the spread between the strike price of the options and the market price of the collateral as well as deposit at least one of the underlying asset on the protocol in order to mint USDO.

Therefore, to hedge its collateral, Otto uses options with no expiration date and custom strike prices and sizes. These so-called Eonian options, an innovation of Otto, will be detailed later in this document. However, these options require the payment of a rolling cost, similar to the funding rate of a perpetual futures contract. By design, the rolling cost is always positive which means that it is collected by short traders and paid by long traders. To create a synthetic short position, it is necessary to buy a put option and sell a call option with the same strike price, with the put option paying the rolling cost, and the call option receiving it.

According to our thousands simulations, it turns out that the rolling cost is almost entirely offset for a long put and a short call taken with the same strike price. This allows Otto to effectively hedge the volatility of users' collateral without being exposed to the funding rate of perpetual futures contracts.