Move over Black Scholes: Potion is Reinventing Derivative Pricing Through A Unique Social Experiment

Potion Labs (now Ntropika Labs)
6 min readApr 8, 2022


Published in

A novel risk management protocol that puts the power of the Kelly Criterion into the hands of the DeFi Community.

Black-Scholes misses the mark for traders

Until now, modified versions of the Black-Scholes equation have been the gold standard pricing model for the derivatives industry. However, when used as a method of risk management (i.e. trusting the equation’s probabilities as fact), Black-Sholes pricing produces bankruptcy in traders and liquidity providers (LPs) for crypto assets. Why? Because Black-Scholes is focused on calculating a price for the derivative and not analyzing whether the bet is worth the risk.

Crypto markets are a lot more volatile than more traditional asset classes, meaning they experience wilder moves much more frequently. The bottom line: Black-Scholes prices risk too cheaply in some cases and too expensive in others, and as a result it exposes LPs to losing their capital when betting systematically.

The mathematics of long-term crypto survival

The Kelly Criterion is a systematic allocation strategy used by some of the best risk practitioners in the world (including titans such as Taleb, Buffett, Simons, and Thorp). It provides a mathematical framework to make optimal capital allocation decisions under uncertainty and has been shown to work in practice.

In fact, it is the perfect choice for LPs, because it is optimized for survival and growth over repeated continued risk exposure, as opposed to opportunistic single event risk tasking.

As Nassim Taleb puts it: “Smoking one cigarette won’t kill you, but repeated smoking over years will. Kelly wouldn’t allow this”. Kelly selects for trades that when performed repeatedly lead to consistent long-term gains, similar to the strategy of the house in a casino.

Pushing current boundaries with the DeFi Potion Protocol

Based on an adaptation of the Kelly Criterion, Potion Labs has created a one-of-a-kind bonding curve that prices any asset depending on the LP’s risk. That means it already addresses one of the greatest drawbacks of existing price insurance solutions in DeFi: the severe risk in long-term liquidity supply exposing LPs to extreme capital losses.

But the Potion Protocol goes beyond that. In reality, it is a Kelly ‘Machine’, in the sense that it allows LPs to exchange collateralized risk contracts openly and transparently on-chain, with all of the transactions being automatically risk-managed by the protocol.

In addition, due to its intuitive UX, the Potion Protocol will let both unsophisticated and seasoned traders access a broader range of price insurance products in deeper marketplaces, benefiting from the automatic routing of their orders to the cheapest combination of LPs available. This speaks to the two other major drawbacks of existing price insurance solutions in DeFi: a complex user experience and a poor product choice for price insurance buyers.

Through Potion Analytics, users and LPs will be provided with sophisticated risk analytics and simulation capabilities. This includes a comprehensive set of interactive tools for Kelly-Criterion-based bonding curve analysis:

· Risk Optimization: in financial markets, the Kelly Optimization Criterion is a strategy for reducing risk and increasing projected return. This move is the strategy taken by Potion Protocol.

· Sustainable Alpha: a successful investment has a greater success rate than a bankruptcy. Potion Analytics achieves this purpose using a Monte Carlo backtesting technique.

· Programmable Alpha: Holding a sustainable alpha benefits the investor in the near term, but what about in the long run? Potion Analytics, once again, provides a backtesting layer to create return and risk estimates.

Based on the above, Potion protocol has the potential to become a powerful risk management layer in DeFi, offering transversal products like insurance from an automated smart contract.

A novel NFT game to release the Potion Protocol into the public domain

As developers, Potion Labs are deep believers in decentralization and this ethos has translated into the launch strategy of the Potion Protocol. By participating in a novel NFT game, ‘Potion Unlock’, players will be able to work with other community members to release the protocol into the public domain. With this one-of-a-kind strategy based on “aggressive decentralization”, Potion Labs seeks to avoid the dangers of a traditional project launch and to maximize community involvement.

The mechanics of the game are simple. The code base of the entire project has been uploaded onto IPFS (decentralized file storage) and encrypted with a strong password. This password has then been split into segments of various lengths and will be distributed across 10,000 unique NFTs.

In order for the code to be finally decrypted and made public, participants will have to collaborate to bring enough of the pieces together. The game itself is totally open-ended: players will have to self-coordinate — without the input of Potion Labs — to find their own solution to the problem.

Once the protocol’s file is decrypted and released into the public domain, a community with ‘skin in the game’ will have been formed. This community will then have power and stewardship over the future of the Potion Protocol as a public good.

In this way, Potion Labs hopes to have created a new, fully legally compliant paradigm for decentralized software release into the community.

Potion NFT symbolism and rarities

Potion Unlock NFTs commemorate the release of the Lab’s Kelly Machine and its key technical breakthrough: the synthesis of the Kelly Criterion into a bonding curve. To celebrate this, each NFT symbolically and artistically represents a different insurance contract. Various characteristic artifacts are used in each NFT to represent the specific parameters of an insurance contract.

The collection of NFTs is made up of 10,000 unique pieces, which together embody one of the first artistic renderings of a bonding curve as well as providing a dictionary of Kelly Criterion bonding curves. Importantly, Potion NFTs are digital collectibles, not financial instruments: only the original NFT minters can participate in the Potion Unlock game.

There are also 6 NFT types or “rarities” in the game, each with a different “decryption power” (length of the password segment), giving the various players different capabilities and powers. Each NFT rarity will also have a different “redundancy” level (based on the number of duplicates), so no single holder can block the resolution of the game.

Becoming part of the Potion community

DeFi enthusiasts can join the Potion Discord channel to access the latest community updates and to engage with the excitement building around Potion Unlock.

Starting on February 28th, the majority of Potion NFTs will be sold to the public via a Dutch-style auction of the Fellowship, Advanced and Legendary Potion NFTs. High profile DeFi and NFT participants are expected to take part, but anybody can potentially participate by whitelisting themselves and registering their MetaMask wallets on the Potion Unlock website.

To strengthen the participating community, two Potion NFT rarities (Kelly Knights and Wise Wizards), have already been distributed through a $12M private sale last January. These were bought by prominent DeFi players such as Polychain, Placeholder, Maven 11, Pantera, The LAO, MetaCartel, Parafi, Spartan, Robert Leshner, Fernando Martinelli, Synthetix founders, Crypto Plaza, Roble VC, CULTUR3, Lemniscap, Zee and beToken Capital, among others.

Finally, Potion’s early community members (OGs or Original Gangsters), also received a generous allocation of Potion OG NFTs at no cost, in recognition for their early community support and inspiration. A significant number of OG NFTs have also been made available in the form of airdrops to 1,000 leading members of prominent DAOs, with the goal of building a high quality community around the project.

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