Hedging with Options

Why hedge with options?

Options give you convex protection - your downside is capped but your upside remains intact (for long options). This is fundamentally different from linear hedges like perps or spot sales, which eliminate both downside AND upside. If you're worried about a crash but believe in the long-term thesis, options let you protect yourself without giving up the rally.

The cost of hedging is the insurance premium. Like all insurance, it's most valuable when you need it most - but you pay for it either way. Understanding when the cost is worth it (when crash probability crash severity > premium) is the core of options-based risk management.

Protective puts: full downside insurance

A protective put is simply buying a put option against a long position. If you own ETH and buy a put at $1,800, your effective cost basis if assigned is $1,800 minus the premium you paid. If ETH stays above the strike, the put expires worthless and you only lose the premium - but you kept all the upside. This is the cleanest hedging instrument.

The tradeoff: put premiums are expensive in high-volatility environments (exactly when you most want insurance). A 30DTE 10% OTM put might cost 3-5% of notional. That's 3-5% of your portfolio, every 30 days, just to hold insurance. For long-term hedgers, the theta burn can exceed the expected value of the protection.

Collars: protection without full premium cost

A collar addresses the premium problem by selling a call option to fund the put purchase. If you buy a $1,800 put for $60 and sell a $2,200 call for $40, your net cost is only $20 - much cheaper than the full $60 put. But you now have two new obligations: if ETH rises above $2,200, your call is exercised and you sell at $2,200 (missing any upside above that). You've exchanged full upside for near-zero-cost downside protection.

Collars are most useful when you've already had a big gain and want to lock in profits without paying full put premium. The call sale funds the hedge but caps your upside. Many institutional traders use collars on large positions because the math of partial protection at low cost beats paying full premium.

Iron condors: profiting from range-bound markets

An iron condor used as a hedge means you're selling options in a range you expect ETH to stay within, while buying protection outside that range. If you hold ETH and sell an iron condor, you collect premium that partially offsets your ETH exposure. If ETH stays in your range, you profit from the iron condor and your ETH position stays intact. If ETH breaks out in either direction, one side of your iron condor loses - but the loss is capped by your long strikes.

Iron condors as hedges work best in low-volatility environments where you expect range-bound action. In high-IV environments, the premium you collect is higher (more profitable) but the risk of a breakout also increases. The width of your short strikes determines your profit zone - wider = more profit but more risk.

Perps vs options for delta hedging

A perp is a perfect linear hedge: $1 of ETH short perp = $1 of ETH long exposure. But an option's delta changes with spot - so a perp hedge of an option position is only exact at one price level. As spot moves, the option's delta shifts and the perp hedge becomes imperfect. This is "gamma risk" - the risk that your hedge ratio changes as the market moves.

For small moves and short durations, perp hedging works well. For large moves or longer durations, the gamma risk compounds. Dynamic hedging - rebalancing the perp position as spot moves - closes the gap but incurs transaction costs on every rebalance. The tradeoff between transaction costs (dynamic hedging) and gamma risk (static hedge) is at the heart of options market making.

Frequently asked questions

When should I use a protective put vs a covered call for hedging?

A protective put costs premium but has no upside cap - you keep all the ETH upside. A covered call caps your upside but you collect premium (it reduces your cost basis). If you're worried about a crash and want full protection: buy a protective put. If you're holding ETH and want income while accepting a ceiling: sell a covered call. Protective puts are expensive in high-IV environments; covered calls are most profitable when IV is high.

What's a collar strategy and when does it make sense?

A collar = long put (protection) + short call (income to fund the put). You buy a put at one strike and sell a call at a higher strike, creating a zone of protection. The call sale funds the put purchase, so net cost is near zero. If ETH rises above the call strike, you're called away - you miss further upside but are protected on the downside. Collars are used when you want to hedge but don't want to pay the full put premium out of pocket.

How does using a perp differ from using options for delta hedging?

A perp is a linear instrument - $1 move = $1 PnL. An option has convex payoff - its delta changes with spot. Using a perp to hedge an options position is only an approximation because the perp's delta is always 1 while the option's delta varies. For small moves, perp hedging works well. For large moves, the option's gamma means the hedge ratio changes, leaving you over- or under-hedged. This 'gamma risk' is why large hedge funds use options themselves (or dynamically rebalance their perp hedge as spot moves) rather than a static perp position.

What is delta hedging and why does it need to be rebalanced?

Delta hedging means making your overall position delta-neutral - offsetting directional exposure with the underlying or a derivative. If you're long a call with delta 0.50, you're effectively long 0.50 ETH per contract. To hedge, you sell 0.50 ETH (or short 0.50 ETH notional in perps). But when ETH moves, the call's delta changes: if ETH rises, delta increases toward 1, meaning your hedge is now too small. You must buy more to rebalance. This dynamic rebalancing is why delta hedging has transaction costs that must be factored into the option's breakeven.

Can you hedge DeFi positions on-chain with options?

Yes - Lyra lets you buy put options to hedge ETH holdings, similar to a protective put. Dopex's option decks let you construct collars and spreads. Hegic's put-seller vaults let you sell cash-secured puts against USDC collateral. The hedging effectiveness depends on the liquidity and bid-ask spreads of the options AMM - thin markets mean wider spreads and imperfect hedges. For large hedge ratios, you'd split the position across multiple strikes or protocols to avoid moving the AMM's price.

What's the cost of carry in options vs perps for hedging?

Cost of carry = financing cost - yield earned. When you hedge with a perp, you typically pay the funding rate to maintain the short perp position. If funding is 10% annualized and ETH staking yields 4%, your net cost is 6%. With options, you pay the put premium upfront - no funding rate, but the premium reflects the market's expectation of future moves. In high-funding environments, perps can be expensive; in high-vol environments, options premiums can be more expensive. Comparing the cost: a 30DTE 10% OTM put might cost 3-5% of notional, while 30 days of perp funding at 10% annualized is ~0.8%.

What is an iron condor and when is it a good hedge?

An iron condor = bull put spread + bear call spread. You sell an OTM put and buy a further OTM put (protection on the downside), and sell an OTM call and buy a further OTM call (protection on the upside). You profit when the underlying stays in a range. It's used as a hedge when you expect low volatility or a range-bound market, and want to earn premium that offsets other positions. If you have a long ETH position and sell an iron condor around it, you collect premium that offsets some downside risk while keeping most of the upside.

Related reading

• Options Overview - Black-Scholes, Greeks, and the on-chain options landscape.
• The Greeks - delta, gamma, theta, and vega - the core of hedging math.
• Calls and Puts - payoff diagrams and the mechanics of protection.
• Lyra - how Lyra's AMM handles delta hedging protocol-level.
• Options Strategies - iron condors, straddles, and more.
• Perpetual DEXs - the linear hedging instrument for delta management.
• DeFi Glossary - delta hedging, protective put, collar, iron condor definitions.