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Strike Selection Mechanism

How Polysynth maximises yields while minimising downside.

Polysynth product offerings include various types of options strategies ranging from simple vanilla covered calls and puts to iron butterfly and iron condors. Some of these are one-leg strategies like covered calls and covered puts i.e. a call or put option will only be sold on a single strike price, hence only one strike price is required to be determined. On the other hand, bull and bear spreads require two strike prices and iron butterfly and iron condors require four strikes.

Selecting the right strike is very critical for the strategy to generate high yields as it determines the premium that option sellers will receive. Selling a far out-of-money option might have lesser risk but also receives a low premium. Systematic selling of options requires optimal selection of strikes based on market volatility to enhance returns.

Polysynthβs objective is to make this mechanism - **Autonomous, Decentralised **and** Scalable** in the long term by devising an optimal model with hyperparameters that can be decided by the community through governance.

How does it work?

The simple question to answer is - how does the model decide how far out of the money strike needs to be selected? Selling a fixed % out of money strike (example 30%) from the current spot price is not optimal as it does not account for market volatility and the premium will be very low in periods of low volatility.

Option Delta is one of the four measures options traders use for analyzing risk. It measures the degree to which option premium will change with the underlying. Its value ranges from -1.0 to 1.0. An Option Delta of 0.5 indicates that the option premium will change by $0.5 if the underlying price moves by $1.

The full mechanics of the strike selection model is as follows:

- 1.
**Estimate Implied Volatility** - 2.
**Fetch Spot Price** - 3.
**Input Pre-Defined Delta Value**

Implied volatility is estimated using Deribitβs DVOL index. The DVOL gives a forward-looking annualised expectation of volatility using order book data for options on Deribit. For example, DVOL = 90 gives an expected daily move of 4.5% (more precisely, you should divide DVOL by the square root of 365 to get an estimate of the expected daily move).

The current spot price is fetched from Chainlink and the Delta value is pre-defined and set in the contract. A fixed delta value will result in the model picking the strike price far from the spot if the implied volatility is high and vice versa if the implied volatility is low.

All the parameters above are used in the Black-Scholes model to compute the strike price and options premium.

Delta Value Selection

The Delta value is currently decided by the Polysynth team based on extensive backtesting and optimization. It is set to 0.1 for covered calls and covered puts. It will eventually be governed by the community. The entire computation is done on-chain.

Future Considerations

Polysynth team aims to make this operation truly autonomous and community governed along with launching multiple types of vaults with different Delta values to help our users achieve diversification.

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