How to Reduce DeFi Price Risk with Delta Neutral Strategies | by Treehouse | coin monks

In a highly volatile environment, investors may opt for low-risk strategies that still provide them with returns. A basket of strategies that investors often participate in are delta neutral strategies.

Delta refers to the theoretical estimate of the magnitude of a derivative’s change in value relative to a $1 change in the price of the underlying asset. A derivative is an investment vehicle, such as a stock option, whose value is derived from the performance of the underlying assets. The term delta neutral describes a portfolio that uses multiple positions to balance positive and negative deltas such that the total delta of assets is zero.

Essentially, a delta-neutral strategy aims to minimize a portfolio’s exposure to price volatility and mitigate its reaction to market movements. This article discusses four delta-neutral strategies that retail investors can consider when it comes to cryptocurrencies: spot futures arbitrage, spot perpetuals funding arbitrage, stablecoin farming, and delta-neutral yield farming.

Learn more about delta neutral strategies in our insights article here!

Stablecoin farming is similar to regular yield farming, except that the two assets held in the liquidity pool are stablecoins, allowing for almost no temporary loss from this position. By being tied to the same underlying asset, fiat currency in most cases, users can generate income simply by holding an asset that is resilient to market fluctuations. This is why stablecoins have become a linchpin in the DeFi stack and stablecoin farming is such a popular strategy among investors. In theory, investors engaging in stablecoin farming only face idiosyncratic risk.

Stablecoin leveraged farming

Typically, stablecoin pools offer annual percentage returns (APYs) starting at 8%. To optimize yield, users can also use farm stablecoins. While leverage farming volatile assets can be risky, leverage farming stablecoins is inherently less risky because there is no price movement in stablecoins.

Using a sample portfolio with a starting amount of 1000 BUSD, the effects of leveraged stablecoin farming can be seen as follows:

Referring to Figure 1, if the principal amount is 1000 BUSD, a deposit of 500 BUSD and 500 USDT would be required since the two assets deposited in the liquidity pool, BUSD and USDT, should be equal in total value.

For a 6x leveraged position, an investor must borrow BUSD 5,000 in addition to the principal of BUSD 1,000. Next, he will convert this borrowed amount into 2000 BUSD and 3000 USDT to meet the requirements to join a stablecoin liquidity pool.

Therefore, the investor will deposit BUSD 3,000 and USD 3,000 worth of $ 6,000 with the possibility of earning six times the return than if they had only traded with the principal amount of BUSD 500 and USD 500.

All-In Stablecoin Leverage Farming?

While leverage farming on stablecoins may seem like an attractive investment in declining or volatile market conditions, it is always important to do your own research (DYOR), especially to know how the stablecoins are backed. For example, a stablecoin like USDC that is backed by a large reserve of assets and verified by regularly published attestation reports is likely to be less risky than an algorithmic stablecoin. Although combining algorithmic stablecoins with fiat-backed stablecoins could yield much higher returns, it carries the risk of greater risk of temporary losses as algorithmic stablecoins can deviate from their peg. In the worst case, the algorithmic stablecoin like the infamous UST could lose its peg entirely.

Read our insights article on stablecoins “The Evolution of Stablecoins: An Important Cog in DeFi”.

Another popular way to achieve delta-neutral returns is to arbitrate the spread, or difference, between the spot market and the futures market. Futures contracts are typically priced at a premium or discount to the underlying market due to various factors such as opportunity cost to capital.

For example, futures on ETH expiring on September 30, 2022 were at a discount of over 2% ahead of the Ethereum merger. This is due to investors shorting futures to hedge their spot ETH positions. Assuming that the spread would converge at expiration (i.e. ETH spot price will equal ETH futures price on September 30, 2022), investors attempted to take advantage of the spread by shorting the spot market and onto ETH -Futures went long.

Figure 2 depicts the payout when the example trade is executed. If the spot and futures prices converge at expiration, the trader can make a $20 delta-neutral profit.

While this strategy allows the user to effectively hedge directional risk by holding both long and short positions, there are other costs and risks associated with these trades. For example, short selling in the spot market incurs a “credit fee” that can eat away at potential spread gains or even turn the trade into a loss. Additionally, execution risk could be an issue if trades are not executed “atomically”, with each part of the trade being done with a separate timestamp. This could result in a slight difference in the starting price of each route.

Frequent users of perpetuals or perps will find that the instrument applies a funding rate to the open position. Funding installments are periodic payments used to pay traders who take long or short positions based on culprits and spot prices. Unlike futures, which automatically reflect real funding costs across term structures, perpetrators enforce actual funding cash flow because they lack an expiry date that forces spot and futures prices to converge.

In a bullish market, the funding rate is positive and traders who are long in the perps contract pay a funding fee to the opposite side (short traders). In a declining market, the funding rate is negative and traders who take short positions have to pay a funding fee to long traders.

Funding rate arbitrage is a delta neutral strategy for traders to hedge their positions in the markets and use this strategy to earn funding fees. For example, a trader can use perps to short an ETH PERP position while simultaneously buying the equivalent value of ETH-USD on the spot market to hedge against price volatility while charging funding fees.

An example of a spot perps trade:

1. Suppose the funding rate for ETH-PERP is 0.01% every 8 hours
2. Long traders must pay short traders to keep their positions open
3. A trader can short ETH-PERP and long the equivalent amount of ETH-USD on the spot market
4. The trader can keep the position open as long as the funding rate stays above the desired threshold for the profit to make sense

Learn more about basic trading strategies in our Learn DeFi article Introduction to Price Risk and Basic Trading Strategies.

Yield farming is a method for investors to generate rewards from their crypto holdings, making their wealth work for them instead of sitting idle in their wallets. Similar to staking, users deposit their tokens into a specific log for some time to “farm” rewards. This is achieved by depositing tokens into a liquidity pool where users are rewarded for providing liquidity to the protocol.

Delta Neutral Yield Farming is a subset of Yield Farming. Investors typically use this strategy when they don’t want to bet on an asset moving in a certain direction. Instead, they construct their portfolio to be balanced in terms of long and short positions. Protocols are available that allow users to employ such strategies. An example would be Francium, a DeFi yield strategy platform that allows users to engage in LP pair delta netural farming.

Delta neutral strategies benefit investors even when market conditions are uncertain. However, it is important to note that such strategies are not aimed at generating astronomical returns. Rather, they serve as a risk-off strategy in volatile market conditions. It is also important for investors to keep up to date with news and price movements of the assets in the liquidity pools they interact with.

Check out our guide to doing your own research (DYOR).

Delta neutral strategies are just one of many ways to hedge against market volatility. Although such a strategy is less risky, it does not mean that there is no risk. It is important to note that there are also risks associated with the underlying assets. As mentioned earlier, algorithmic stablecoins are a good example of how a risk-free strategy can also be risky due to the nature of its assets. Therefore, investors must exercise personal responsibility and due diligence.

Learn more about delta neutral strategies in our insights article here!

At Treehouse we want to empower people to safely engage in DeFi and that includes helping users to properly understand and assess risks. In case you missed it, check out our recommended risk-relevant parts list!

1. How to understand metrics in DeFi
2. The truth about audits in DeFi
3. DeFi Risks: What You Need to Know
4. How to manage your DeFi risks with this framework
5. Introduction to price risk and basic trading strategies
6. Flash Lending and Flash Lending Attacks? What are they and how to prevent them?
7. A look back at past crypto winters
8. How to measure your price risk in DeFi
9. Diversify your portfolio to manage your DeFi price risk
10. How to manage DeFi price risk by setting stop losses

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