Overview of alternative DeFi strategies, other than stablecoin pools, in order to generate sustainable excess liquidity for dips while reducing exposure to price fluctuations.
Introduction
Given the current uncertainty in the markets, this article analyzes the opportunities that DeFi offers us to ensure a passive income while reducing exposure to the current price action. A dollar-neutral portfolio has equal dollar-value investments in short and long positions. By using several financial assets, the positive and negative deltas are balanced until the overall delta of the combination of the positions equals zero. Delta neutral strategies are often used with options and derivatives, or to protect a position temporarily, as when we are in a delta neutral position we would neither win nor lose even if the underlying asset changed in price.
As explained above, the neutral delta strategy is one that, adding all the deltas, the general delta is equal to or very close to zero. What does this mean? A delta equal to zero means that for each unit that the underlying varies, our strategy will not vary. Delta measures how much an option’s price changes when the underlying security’s price changes. As the values of the underlying assets change, the position of the Greeks will shift between being positive, negative, and neutral. Investors who want to maintain delta neutrality must adjust their portfolio holdings accordingly, manually or, as we shall see, algorithmically.
The next question that arises would be, how do we obtain profits if the movement of the price to one side or the other does not generate them? It should be noted that the movement of the underlying price is not the only factor that affects profitability. Options traders use delta-neutral strategies to profit either from implied volatility or from the time decay of the options. Of Course, Delta-neutral strategies are also used for hedging purposes.
This article focuses on the automated opportunities for hedging strategies within the crypto space. These strategies are growing exponentially in popularity lately given the current market conditions and the huge potential that they have.
The different DeFi platforms reward users for their liquidity. This means that if we find a way to lend/ stake/ farm certain assets avoiding the risk of impermanent loss or price fluctuations, we would get an interesting return while reducing exposure to volatility and risk. A consistent, high, and healthy APR would be suitable enough to generate excess liquidity and accumulate Blue Chips for the long run.
Strategies included:
- Delta Neutral On Synthetics
- Automated Option Vaults
- Automated Basis Trading
- Pseudo Delta-Neutral Farming
Delta Neutral On Synthetics
(Mirror/ Aperture Finance)
Delta-Neutral strategy on Mirror has existed for several months now and has proven to be one of the highest low/ medium risk farms. Investors have been earning profit regardless of the underlying asset increases/decreases at price by owning and shorting the asset at the same time. The Mirror strategy consists of taking advantage of the Annual Percentage Rate (APR) that the Mirror protocol offers us, going both short and long on the same asset and in equal parts. This allows us to neutralize the changes in that asset while we carry out our strategy. This has been a great strategy and tested last year to generate a higher return by being in UST than we could get just by leaving our deposits in Anchor, while still not being exposed to Impermanent Loss.
Source: Aperture Finance
The key would be to buy the same amount and at the same price for the asset that we are betting on to go down. Meanwhile, our profit comes from the APRs offered in form of the protocol governance token, MIR, rewarded to us for using the platform and providing liquidity. Note that to short an asset we use our AUST as collateral (our UST keeps generating a high and stable yield on Anchor’s earn) and to buy the same amount of that asset we use UST.
This can be executed in 3 different ways in Mirror:
1. Short farm the mAsset, buy the equivalent number of mAsset that was shorted and hold (easiest to execute but typically the lowest yield as short farm yield fluctuates a lot).
2. Short farm the mAsset, buy the equivalent number of mAsset that was shorted, provide liquidity with an equivalent amount of UST (LP) to long farm (highest yield with some exposure to impermanent loss).
3. Borrow the mAsset, and provide liquidity with an equivalent amount of UST (LP) to long farm (exposure to impermanent loss).
Recently, Aperture Finance has been able to automatize the delta-neutral strategy on Mirror. Aperture has developed smart contracts to automate the transactions and provide new features such as liquidation protection, Capital efficiency, Auto-compound and rebalance, etc). By depositing UST in a certain mAsset vault, investors could be able to outperform the already high yield of ~19.5% provided by Anchor.
Based on Aperture’s estimation, this should be the estimated return calculation of a selected mAsset:
mSQ short-farm APR: 23.28%; APY (monthly compounded): 25.93%
mSQ long-farm APR: 17.86% ; APY (monthly compounded): 19.40%
mSQ long-farm SPEC APY: 3.26% (12/29/2021, instantaneous)
aUST Collateral on Anchor APY: 20%
Overall: (20% * ⅔) + (25.93% * ⅓) + (19.4% + 3.26%) * ⅔ = 37.08%
General Formula for Avg. APR = (Anchor APR x 2⁄3) + (Short Farm APR x 1⁄3) + (Long Farm APR x 2⁄3)
Risks:
- Liquidation Risks: The short position is still susceptible to liquidation. If the underlying assets grow significantly in a short period, this may result in insufficient collateral and trigger liquidation. It can be argued that by having synthetics that replicate the price of a share, the liquidation risks decrease relative to those of other crypto assets. however, the risk exists and it should be taken into account that in recent months commodities and some stocks have been showing high volatility. Picking mAssets with relatively stable historical price fluctuations or Higher Market Cap might help to reduce the liquidation risk.
- Variable APY from Reward Token price fluctuation: Converting the reward tokens to UST and reinvesting is a way to remove uncertainties caused by the fluctuations of token price. Unlike Anchor, our rewards are not being paid in UST, causing inaccuracies when projecting the actual yield.
- UST De-peg risk: It is imperative to clarify that UST, even though it has shown robustness in the peg, is still a relatively young algorithmic stablecoin, subject to the respective risks of loss of value.
- Smart Contract Risks: There may be unforeseen smart contract risks. The process of this strategy is based on the interaction of several protocols, increasing the exposure to this common type of risk. Moreover, mAssets may present differences with their respective underlying assets.
Automated Option Vaults:
(Katana, Friktion, Dopex, Thetanuts)
With this strategy, investors are not able to fully protect themselves against price changes. Please bear in mind that investors could still be impacted by price changes from the underlying asset.
Options are financial instruments that can generally be used as a hedge against changes in share prices and as a source of leverage to boost profits or losses. Within the universe of options, several strategies come from two types: a call or a put.
A call is a contract by which the investor, or in this case, the buyer, has the right, but not the obligation, to acquire an asset at a certain price (called a strike) on a pre-established expiration date. The value paid for having that right is called the premium. Under this dynamic, the buyer expects that the underlying asset will become more expensive, so he seeks to secure a lower purchase price in advance.
On the other hand, a put gives the investor the right, but not the obligation, to sell an asset at a predefined price, at a given time in the future. The buyer of this instrument trusts that the price of the underlying asset will fall and therefore protects himself by paying a premium. This ensures a definite sale value that is higher than what his expectations indicate.
This type of financial derivative opens the door to numerous strategies with all their benefits and also, with all their risks.
Fortunately, there are some alternatives for investing in these types of strategies without being an options expert. Various DeFi protocols across multiple chains offer automated option vaults whereas users simply have to deposit crypto assets or cash to earn a premium.
Options Vaults focuses on income generation strategies, running automated covered call selling programs. Once deposited, funds are deployed into the current epoch and the Vault becomes an active portfolio manager. Investors’ deposits are auto-compounded weekly. Option strikes and expiries are algorithmically determined to maximize your returns and minimize the chance of an option being called or an underlying asset assigned. Withdraws can be pre-set and claimed once the withdrawal window opens.
Currently, options vaults across different protocols provide the well-known strategies of Covered Call and Cash Secured Put.
Covered Call
This strategy involves holding an existing long position in a tradable asset and writing (selling) a call option on the same asset, to increase the overall profit an investor will receive.
A covered call is used by investors who are fundamentally bullish but believe that the underlying asset will rise slowly, or not, beyond a certain price point. In these circumstances, the investor can profit from both the long call position and the short position.
This allows the investor to earn a higher return than he would earn if he held the long position alone. If your bullish view is incorrect, the short call serves as a hedge to offset some of the investor’s losses incurred as a result of the asset’s falling value.
By defining fT as the payoff at maturity T; S0 is the stock price at the time t = 0 of entering the trade; ST is the stock price at maturity; K is strike price; C is the net credit received at t = 0; S* is break-even price; Pmax is the maximum profit at maturity; Lmax is the maximum loss at maturity. We have:
fT = ST − S0 − (ST − K) + C = K − S0 − (K − ST ) + + C
S∗ = S0 − C
Pmax = K − S0 + C
Lmax = S0 − C
Covered calls work because an investor who is currently long in an asset gives up their right to sell that asset at any time for market value. Instead, under the obligations of a call option, they must sell the asset to the buyer on the strike price expiration date, provided the buyer exercises his right to buy.
From the perspective of the seller of the call, he would only be concerned if the price of the underlying asset rose to levels above the strike price, at which point the buyer can be expected to exercise the option. However, if the sellers are already long on the underlying instrument, they would already benefit from the move higher.
Call buyers will normally exercise their right to buy if the underlying price exceeds a predetermined strike price on or before a specified expiration date. If the underlying price does not reach this strike price level, the buyer is not likely to exercise their option because the underlying asset will be cheaper on the open market.
DeFi Options Vaults implies having a long position in a particular crypto asset and writing a call option on that same asset to realize additional income from the option premium. In this case, the Smart Contract writes a covered call option on the token. By selling covered call options, the profit from an increase in the price of the underlying index is above the exercise price but continues to bear the risk of a decline in the index.
Cash-secured Put Selling
The cash-secured put involves writing a put option and simultaneously setting aside the cash to buy the stock if assigned. The goal is to be assigned and acquire the stock below today’s market price. Whether or not the put is assigned, all outcomes are presumably acceptable. The premium income will help the net results in any event.
The investor is bullish on the underlying stock and hopes for a temporary downturn in its price. If the stock drops below the strike, the put may be assigned. That would allow the put writer to buy the stock at the strike price. The effective purchase would be even lower: strike price less the premium received.
This strategy (a.k.a. “sell-write” strategy) amounts to shorting the underlying asset and writing a put option with a strike price K against the asset position. The trader’s outlook is neutral to bearish. The covered put strategy has the same payoff as writing a call option (short/naked call). While maintaining the short stock position, the trader can generate income by periodically selling out-of-the-money put options:
fT = S0 − ST − (K − ST ) + C = S0 − K − (ST − K) + C
S∗ = S0 + C
Pmax = S0 − K + C
Lmax = unlimited
Whereas, as explained above, fT is the payoff at maturity T; S0 is the stock price at the time t = 0 of entering the trade; ST is the stock price at maturity; K is strike price; C is the net credit received at t = 0; S* is break-even price; Pmax is the maximum profit at maturity; Lmax is the maximum loss at maturity. We have:
While cash-hedged put options can provide the profit potential, they can also carry substantial risk.
There are two principal risks. First, the stock might not only dip but plummet well below the strike price. The investor must be comfortable with the strike price as an acceptable long-term acquisition price, no matter how low the market goes.
By selling a cash-covered put, you can collect money (the premium) from the option buyer. The buyer pays this premium for the right to sell you shares of stock, any time before expiration, at the strike price. The premium you receive allows you to lower your overall purchase price if you get assigned the shares.
However, Automated Option Vaults have cash settlements. If options expire on the money, in the case of a covered put, we are not going to actually purchase the underlying asset, we are going to lose a portion of our deposited amount. If the price of the underlying asset vault stays above the strike price, depositors get to keep their stablecoins and earn the APY from the premium. On the other hand, if it goes below the strike price, we get to keep our yield but we lose a portion of our deposited investment to pay the difference that the put buyers are rewarded.
Cash-secured put vaults focus on generating yield on stablecoin deposits. The volt runs automated cash-secured put programs. Deposits are auto-compounded weekly. Option strikes and expiries are algorithmically determined to maximize your returns and minimize the chance of an option being called or an underlying asset assigned. Withdraws can be pre-set and claimed once the withdrawal window opens.
Cash settlement Vaults can provide a high organic yield without being exposed to volatile assets. APYs by depositing USDC, UST, USDT varies from 10% to 50% by taking advantage of crypto markets volatility. This return can be more sustainable because it comes from monetizing the high volatility of the underlying asset and injecting this yield into Defi through the payment of option premiums. This means that the base yield from DeFi Option Vaults does not rely on token rewards at all. It also solves the problem of diminishing returns (or crowding out) from increasing sizes of LP pools, as the base yield is sourced from a large external options market.
Vaults accept UST/USDC deposits and earn yield via an automated ETH put selling strategy. The strategy works by first using the underlying USDC/UST on Derivatives DEXs and minting out-of-the-money ETH puts in return. The vault then sells these put options, earning the option premium as the initial yield. If the price of ETH is above the strike price at the time of expiry, the vault earns the full value of the options it sold and can repeat the strategy, compounding its USDC over time.
Risks:
As stated above, selling insurance for a crypto asset is not for free since we are still exposed to the underlying asset’s price action. It should be noted that the vault may incur a loss if the price of ETH is below the strike price of the put options at the time of expiry. If so, the options are deemed to have expired in the money and can be exercised for the USDC locked by the vault, resulting in a potential loss for the period. Strike prices are chosen such that these events are less likely.
Source: Friktion Analytics — ETH Cash secured Put Vault
Option vaults operate in a time-round structure, meaning funds are locked in the strategy during the period. Each period begins depending on the protocol used (weekly, monthly). At the beginning of a new epoch, the strategy rolls over and new options are minted. At this time, deposits in the deposit queue are initiated into the strategy and begin earning yield. If a user deposits anytime before the start of the period, their funds will remain in a deposit queue and will only begin earning yield starting with the new Epoch.
Automated Basis Trading Using Perps
(Lemma Finance)
Basis trading is a financial arbitrage trading strategy that involves trading a financial instrument, such as a financial derivative or a commodity, to profit from the apparent price mispricing of the security (also known as cash and carry trading).
Lemma Protocol uses a market-neutral derivatives position to issue a stablecoin and generate a sustainable yield. Investors earn Yield by lending assets to traders and earn sustainable yields denominated in the native protocol stablecoin USDL. Basis trading is a market-neutral strategy, meaning that if you deposit ETH, you will lose exposure to ETH price action.
Lemma Finance’s strategy profits from funding rates. These Rates exist so to keep the price of the perpetual contract in line with the underlying spot asset’s price. If the funding rate is negative, short traders pay fees to long traders and vice-versa. The protocol’s vault’s yield comes from the funding rates generated by the short position backing USDL. This means that Lemma works on the assumption that the market tends to have positive funding rates most of the time, and has a short position to take advantage of that. So, there is a risk here during bearish price action when sentiment is, obviously, overall bearish. There would be a problem with the protocol’s position if the funding rates remain negative for a long period and it would have to be adjusted.
The protocol´s team explains how to Create a market neutral position as follows:
- User deposits 1 ETH on Lemma.
- Lemma will move that 1 ETH to a decentralized derivatives exchange.
- Lemma will use it as collateral to short the ETH-USD inverse perpetual contract with no leverage.
Assume the price of ETH is 1000 USD:
- If the price of ETH increases to 1100 USD, then our short will have lost 100 USD, but our collateral will have gained 100 USD in value, meaning our portfolio’s overall value will have stayed at exactly 1000 USD.
- If the price of ETH decreases to 900 USD, then our short will have gained 100 USD, but our collateral will have lost 100 USD in value, meaning our portfolio’s overall value will have stayed at exactly 1000 USD.
In this example, when a user deposits 1 ETH for 1000 USD, Lemma will create a portfolio of 1000 “synthetic USD” on their behalf. Lemma will then mint 1000 USDL to represent the user’s stake in the overall Lemma “synthetic USD” portfolio.
Risks:
- Smart contract risks.
- Stablecoin de-peg: Investors are exposed to the protocol’s native stablecoin risks.
- Persistent Negative Funding Rates: As explained above, Lemma works on the assumption that the market tends to have positive funding rates most of the time, and has a short position, being negatively exposed to bearish price action.
- Derivative DEX risks: Lemma is built on top of various decentralized derivatives exchanges and as such, it is potentially vulnerable to an exploit of their smart contracts as well as a forced settlement of perpetual.
Pseudo Delta-Neutral Farming
(Francium, Tulip, Alpaca Finance, Delta One)
With this strategy, investors are not able to fully protect themselves against price changes. Please bear in mind that with this strategy, we are still impacted by price changes from the underlying asset.
The risks involved are relatively less than traditional farming (only a long position on the assets included in the LPs). A Pseudo Delta-Neutral strategy helps us to focus only on yield gains, regardless of whether we are bullish or bearish on the underlying asset.
This strategy is made possible by protocols that offer leverage farming. In some cases, it is possible to decide how much we can borrow and therefore go long and short at the same time. It consists of taking a long and short position in an asset pair simultaneously to minimize the effect on your portfolio when the asset’s price fluctuates.
Neutral Hedge Strategy position setup procedures as explained in Francium’s docs:
Begin by depositing a total of $400 USDC into the following positions:
- Deposit $100 USDC in Position: 3X ETH/USDC (borrowing USDC)
You have deposited $100 equivalent USDC and borrowed $200 USDC. The total position value is $300 USDC. Since it is a 50%-50% position setting, you will have a $300 — $150 = $150 cost ETH LONG exposure.
- Deposit $300 USDC in Position: 3X ETH/USDC (borrowing ETH)
You have deposited $300 USDC and borrowed $600 equivalent ETH. The total position value is $900 USDC. Since it is a 50%-50% position setting, you will have a $600 — $450 = $150 cost ETH SHORT exposure.
Both the long position and short exposures are hedged.
Source: Francium — whETH Price Simulation
In the graph above, the horizontal axis shows the price movement of ETH and the vertical axis shows the profit/loss (%) of the position.
When the price change against the current ETH price is between -35% and ~ 50%, your profit is positive. You would receive the maximum profit when the price of ETH returns to the price it was at when you deposited. For example, in 30 days, you can gain ∼7% if the price of ETH is close to the price when you deposited.
What this means is that it would take a drastic change for the price to impact our strategy. Moreover, the longer the capital is allocated to this pool, the wider the margin of safety is (with positive earnings).
It should be noted that there is a small risk of liquidation and we are still exposed to impermanent loss. The initial position starts with equal amounts between long and short. However, the risk of impermanent loss causes positions to become unbalanced, exposing us to price changes.
Currently, some protocols offer automated balancing services, simply by depositing capital into their vaults. The Automated Vault eliminates market risk by farming long & short positions simultaneously, at optimal sizing, and programmatically rebalancing to minimize the effect of impermanent loss (IL), maintaining the initial neutral exposure.
Please bear in mind that these kinds of vaults have a maximum capacity threshold, so it may not be possible to deposit if the quota is full. However, devs are expanding these strategies across various L1s and new vaults are currently being built.
Overall Risks:
- Smart Contract Risk: Inherently to any protocol, we can see that there are several hazards such as economic exploits, hacks, unexpected occurrences (faulty logic in black swan situations), centralization, oracle, AMM performance, and composability.
- Stablecoin De-peg: Investors should consider diversifying stablecoins holdings (each stablecoin has a unique mechanism to maintain the peg, and may also be exposed to different risks). Also, having a 100% allocation to stablecoins does not mean that asset value is fully protected against a market crash.
- Liquidation Risk: The above strategies require having long and short positions and may use leverage, exposing capital to liquidation risks.
Sources:
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