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Liquidity providers supply sell-side liquidity for traders to take long positions. They can passively open shorts in either calls or puts.
In fact, a liquidity provider is a fee-earning passive trader, according to the put-call parity. If one is bullish, an alternative to buying a call is to short a put. Conversely, when one is bearish, a short call works similarly to a long put.
Unlike a traditional limit short order, a liquidity position on Divergence v1 is minted for the purpose of facilitating swaps. The pool contract is not able to stop a position from being crossed until its liquidity provider signs a transaction to remove liquidity. As the price moves back and forth in its price range, a short position can sell both calls and puts.
A liquidity position is intended to sell calls between [0.30, 0.80]. Once the current price enters its range, it can also sell puts between [1 - 0.80, 1 - 0.30], or [0.20, 0.70].
An option pool's open interests are settled in this logical order:
A long call and a long put settle each other, regardless of the outcome.
Any remaining longs in calls or puts in the pool are then squared with the LPs.
LP's exposure equals the position's net shorts in either calls or puts. The seed liquidity amount and the selected price range determine the maximum net amount of options a position can short.
When removing liquidity, the smart contracts compute a finalized amount of net shorts in calls or puts owed to a position. After reserving collateral for settlement, unused liquidity is returned.
Suppose a liquidity position is minted with collateral. After removing liquidity, it shorts 3 calls and 5 puts. The open short is 5-3=2 puts. Its LP needs to send 2 shield tokens (as puts) to the contract to redeem 2 collateral.
The position's PNL = 2 * ( buyback price - effective price for open shorts)
After the expiry, anyone can call the contract to settle the options. If the calls (or puts) settle out of money, their open shorts become profitable. One collateral can be withdrawn for each.
A position shorts 3 calls and 5 puts at expiry. The open short is 5-3=2 puts. If puts expire out-of-money, its LP can settle the position and withdraw 2 collateral. If the puts expire profitably, however, the collateral reserved for settlement goes to the put holders. No collateral can be withdrawn by the LP.
The following pages provide step-by-step guides about using the protocol interface to complete the above steps: