Additional Parameters

As we have seen in the previous section, the essential parameters of an option are the underlying asset, strike price, expiry time, type, and currency. These apply to instruments created on the Volorca Protocol as well. In this section, we will look at additional parameters that are used to define instruments created on the Volorca Protocol.

Threshold Price

Collateral and Liquidation

Recap from the previous section:

The overall profit/loss for LONGs (buyers) and SHORTS (sellers) is as follows.

The premium is paid from the LONG to the SHORT at the time of purchase.

The Absolute difference in Expiry Price and Strike is paid from the SHORT to the LONG only after expiry.
(in the rest of this docuement, we will refer to the Absolute difference in CURRENT Price and Strike as the price difference. Then the Absolute difference in Expiry Price and Strike is simply the price difference at expiry time.)

Note that for Calls, the largest Expiry Price is, theoretically speaking, infinity, and for Puts the smallest Expiry Price is 0. This means that the largest price difference for Calls and Puts are infinity and the Put strike price respectively.

We need a mechanism to ensure that the SHORT has enough funds to pay the LONG.

On many traditional exchanges, this is done by requiring the SHORT to deposit a certain amount of currency - the collateral, that can cover the payout to the LONG.

When the collateral is not enough to cover the payout, the SHORT is liquidated - the LONG is paid the collateral and the SHORT is forced to close their position.

To avoid getting liquidated, the SHORT may increase their collateral when they see that the price difference is increasing.
Conversely, the SHORT may reduce their collateral when they see that the price difference is decreasing and moving in their favor.

Problem

As mentioned, when SHORTs get liquidated, they are forced to close their position. Depending on the price difference and the exchange's liquidity, LONGs may also be forced to close their position after getting paid the collateral.

Consider this (simplified example):
Suppose we have a Call option with a strike of $30,000, with the underlying being 1 BTC.
Suppose the total collateral deposited by the SHORTs is $5,000.
If the BTC prices hits $35,000, and the SHORTs have no extra money to deposit, the SHORTs will be liquidated.
The SHORTs' positions will be closed and the $5,000 collateral will be paid to the LONGs.

Now, if the LONGs' positions remain open, when the BTC price then hits $36,000, this means that the LONGs are entitled to another $1,000.
Barring any "magical" money inflow, there is nowhere for the LONGs to get the additional $1,000 from.
For proper accounting, the LONGs should also be forced to close their positions when their counter-party, the SHORTs, were forced to close their positions. (The LONGs will still receive the collateral.)

This means that, even if the BTC price moves in the LONGs' favor, they could be forced to close their position.
In some cases LONGs may be happy to simply receive the payout and walk away, but for those that are holding this LONG position as part of a multi-legged hedge, one leg of the hedge will be lost pre-maturely.

Another issue is that the LONGs may have unfairly overpaid for the premium if they had expected a higher price at expiry but had their position closed early at a lower price.

Volorca's Solution

To mitigate this, the Volorca Protocol introduces the Threshold Price parameter for each option contract. The Threshold Price is the price at which SHORTs are liquidated. It determines the maximum payout from the SHORTs to the LONGs.

For Calls, Threshold Price must be higher than the strike price.
For Puts, Threshold Price must be lower than the strike price.

In this manner, the point of liquidation is transparent to both LONGs and SHORTs from the beginning.

SHORTs that wish to move to a higher Threshold Price may do so by exiting their position and entering a SHORT position in a separate instrument with a higher Threshold Price.

Version

Due to the possibility of early liquidation, a new contract may be created with the same parameters if the asset price comes back into range.

For example, a BTC Call option with strike at $30,000, threshold at $35,000 and expiry on 2023 June 1st may get liquidated when the BTC price hits $36,000 on 2023 May 28th.

On 2023 May 28th, the BTC price hits $35,500. Liquidation happens - both SHORTs and LONGs have their positions closed and the collateral deposited is paid to the LONGs.

Now, suppose on May 29th, the BTC price drops to $31,000. An option contract with the same parameters can be created again.
This contract should be considered a different contract from the liquidated one, even though the parameters are the same.

To differentiate between the two contracts, the Version parameter is introduced.

In our example, we then have two contracts:

The earlier contract that is eventually liquidated.

The later contract that is created after the liquidation, when the BTC price drops back down, before expiry.

Assuming that Version 2 eventually expires without liquidation, the version 2 LONGs will receive the payout, if any, from the version 2 SHORTs at expiry according to the expiration price.

To be clear: Each version of a contract is independent and does not affect the other. LONGs and SHORTs of different versions do not owe or receive anything from each other.

Only one version of a contract with the same parameters (except the version number) can be active at a time. A contract is active if it has not expired and has not been liquidated.