Example Walkthrough

Phase 1: Before Expiry

Suppose BTC/USDC is currently trading at 25,000.

Alice believes that the price in one week will be in the 20,000 to 30,000 range. She decides to make some money from LONG premiums and takes a SHORT position on the following instrument:

Alice deposits 1,000 USDC to the instrument and mints 1,000 LONG positions and 1,000 SHORT positions.

Alice then sells 1,000 LONG on Uniswap and receives 150 USDC in return. She holds on to the 1,000 SHORT.

Bob happens to be the user that bought the 1,000 LONG from Uniswap.

Charlie thinks that BTC will be close to 45,000 in one weeks' time. He wants to take a LONG position, but no one is selling LONGs at this time.

Charlie deposits 500 USDC, obtaining 500 LONG and 500 SHORT in return.

Charlie then sells 500 SHORT on Uniswap and receives 415 USDC in return. He holds on to the 500 LONG.

Dawn happens to be the user that bought the 500 SHORT from Uniswap.

LONG and SHORT balances at this point:

The total USDC locked in the instrument is 1,500. The total LONGs minted supply is 1,500. The total SHORTs minted supply is 1,500.

Suppose no more transactions involving the LONG and SHORT tokens of this instrument takes place until the instrument expires.

Phase 2: After Expiry

Scenario 1: Out-of-the-money

Suppose the expiry price is 30,000 USDC.

This is lower than the strike price, so the instrument is settled OTM. The LONG holders of this call option will not be entitled to any USDC. (LONGs payout = 0) The SHORT holders are entitled to the entire USDC locked in the instrument. (SHORTs payout = 1,500)

Alice's share is (1000 SHORT / SHORTS_MINTED_SUPPLY) = 1000 / (1000 + 500) = 2/3 Dawn's share is (500 SHORT / SHORTS_MINTED_SUPPLY) = 500 / (1000 + 500) = 1/3

Alice is entitled to redeem a total of:
Alice's share * SHORTs payout = (2/3) * 1,500 = 1,000 USDC

Dawn is entitled to redeem a total of:
Dawn's share * SHORTs payout = (1/3) * 1,500 = 500 USDC

Alice redeemed the original amount she put in and also gained 150 USDC from selling the 1,000 LONG tokens.

Dawn paid 415 USDC for the 500 SHORT positions, and eventually redeemed 500 USDC.

Scenario 2: In-the-money, below threshold

Suppose the expiry price is 38,000.

This is 3,000 more than the strike price and 2,000 below the threshold, so the instrument is settled ITM.

LONG holders will be entitled to the following: ''' proportion = (expiry_price - strike_price) / (liquidation_threshold - strike_price) = 3,000 / 5,000 = 3/5 LONGs payout = 3/5 * 1,500 = 900 '''

SHORT holders will be entitled to the following: ''' proportion = (liquidation_threshold - expiry_price) / (liquidation_threshold - strike_price) = 2,000 / 5,000 = 2/5 SHORTs payout = 2/5 * 1,500 = 600 '''

On the LONG side, we have Bob and Charlie.
Bob's share is (1000 LONG / LONGS_MINTED_SUPPLY) = 1000 / (1000 + 500) = 2/3 Charlie's share is (500 LONG / LONGS_MINTED_SUPPLY) = 500 / (1000 + 500) = 1/3

Bob is entitled to redeem a total of:
Bob's share * LONGs payout = (2/3) * 900 = 600 USDC

Charlie is entitled to redeem a total of:
Charlie's share * LONGs payout = (1/3) * 900 = 300 USDC

On the SHORT side, we have Alice and Dawn.

Alice's share is (1000 SHORT / SHORTS_MINTED_SUPPLY) = 1000 / (1000 + 500) = 2/3 Dawn's share is (500 SHORT / SHORTS_MINTED_SUPPLY) = 500 / (1000 + 500) = 1/3

Alice is entitled to redeem a total of:
Alice's share * SHORTs payout = (2/3) * 600 = 400 USDC

Dawn is entitled to redeem a total of:
Dawn's share * SHORTs payout = (1/3) * 600 = 200 USDC

Scenario 3: In-the-money, above threshold

Suppose the expiry price is 46,000.

Since this is above the threshold, the instrument's settlement status is "Liquidated". The SHORT holders will not be entitled to any USDC. (SHORTs payout = 0) The LONG holders are entitled to the entire USDC locked in the instrument. (LONGs payout = 1,500)

Bob's share is (1000 LONG / LONGS_MINTED_SUPPLY) = 1000 / (1000 + 500) = 2/3 Charlie's share is (500 LONG / LONGS_MINTED_SUPPLY) = 500 / (1000 + 500) = 1/3

Bob is entitled to redeem a total of:
Bob's share * LONGs payout = (2/3) * 1,500 = 1000 USDC

Charlie is entitled to redeem a total of:
Charlie's share * LONGs payout = (1/3) * 1,500 = 500 USDC