How to HEDGE your Liquidity Pools positions!? (Like Overnight Finance)
Summary
TLDRThis video discusses the concept of liquidity pools and how they differ from holding assets in spot positions. The speaker explains the nonlinear payoffs in liquidity pools, where liquidity providers face more downside risk and less upside gain compared to holding assets directly. However, the potential for earning fees can make liquidity provision profitable. The speaker also covers strategies to hedge downside risk and maintain a delta-neutral position by borrowing assets and actively managing the hedge, using insights from Overnight Finance's approach.
Takeaways
- đ Nonlinear payoffs: Liquidity providers experience a concave or negatively convex payoff, losing more to the downside and making less to the upside compared to holding an asset spot.
- đž Importance of fees: Despite the nonlinear payoff, providing liquidity can be profitable due to the fees earned, especially when the asset price moves sideways.
- đ Delta hedging: To mitigate downside risk and achieve a neutral position focused on earning fees, it's important to hedge against directional risks.
- 𧩠Strategy overview: A delta-hedged position can be created by lending a stablecoin, borrowing a volatile asset like ETH against it, and then using the borrowed asset to provide liquidity.
- đ Classic short position: Borrowing a volatile asset like ETH against a stablecoin creates a short position, which profits if the asset declines in value.
- âïž Balanced risk: In a delta-hedged LP position, both the value of the LP position and the debt fluctuate together, providing a natural hedge against downside risk.
- âŹïž Upside risk: The main risk in this strategy is a significant upside movement of the volatile asset, which can increase the value of the debt and potentially lead to liquidation.
- đ Rebalancing: To manage this risk, it's crucial to regularly rebalance the hedge, ensuring the health factor stays above a certain threshold, like 1.2.
- đ Overnight Finance strategy: The approach described is inspired by Overnight Finance, which includes keeping a collateral reserve and actively managing the hedge.
- đĄïž Delta-neutral goal: The ultimate goal is to create a delta-neutral position where the primary focus is on earning fees without directional risk.
Q & A
What is a nonlinear payoff in the context of providing liquidity?
-A nonlinear payoff for liquidity providers means that their returns do not follow a straight line. Instead, they experience a concave or negatively convex payoff, where they lose more to the downside and make less to the upside compared to just holding the asset spot.
Why might liquidity providers lose more on the downside and make less on the upside?
-Liquidity providers experience this because, when they deploy an asset into a liquidity pool, the value of their position is affected by both the asset's price movement and the nature of the pool, resulting in this concave payoff.
If liquidity providers lose more on the downside and gain less on the upside, why would they provide liquidity at all?
-Liquidity providers are incentivized by the fees earned from their positions. These fees can outweigh the potential losses or reduced gains, especially if the asset price moves sideways and the provider still earns passive income from the pool.
How can liquidity providers hedge their downside risk in a liquidity pool?
-To hedge downside risk, liquidity providers can use a strategy that involves borrowing a volatile asset like ETH against a stable asset. This borrowing creates a short position that profits if the asset declines, offsetting the losses in the liquidity pool.
What does it mean to be 'Delta hedged' in this context?
-Being 'Delta hedged' means that the liquidity provider has eliminated their directional risk. If the asset price moves down, both the LP position and the debt decrease in value, balancing each other out. The provider's main concern then becomes managing the risk of a significant upward price movement.
What are the main risks when using the Delta hedging strategy?
-The primary risk in this strategy is a significant upward price movement, which could increase the value of both the LP position and the debt, potentially leading to liquidation if not managed carefully.
How can liquidity providers protect against the risk of a significant upward price movement?
-Liquidity providers can protect against this risk by regularly rebalancing their hedge, maintaining a reserve of collateral assets, or keeping their health factor at or above 1.2 to avoid liquidation.
What is the role of rebalancing in this strategy?
-Rebalancing is crucial in maintaining the effectiveness of the hedge. By rebalancing, providers can adjust their positions to ensure that they remain protected against price movements, particularly to the upside.
Why is it important to maintain a health factor of 1.2 or above?
-Maintaining a health factor of 1.2 or above helps prevent liquidation. It ensures that the provider's collateral remains sufficient to cover the borrowed asset, even in the event of significant price changes.
What is the advantage of using a strategy like the one described by Overnight Finance?
-The strategy described by Overnight Finance allows liquidity providers to create a delta-neutral position, where they can earn fees without taking on directional risk. This makes the strategy appealing for those looking to minimize risk while still participating in liquidity provision.
Outlines
đ Understanding Nonlinear Payoffs in Liquidity Pools
The speaker introduces the concept of nonlinear payoffs for liquidity providers, explaining that unlike holding an asset spot, liquidity pools have a concave or negatively convex payoff. This means that as a liquidity provider (LP), one experiences greater losses when the asset's value decreases and smaller gains when it increases, compared to simply holding the asset. Despite this, providing liquidity can be profitable due to the passive income generated from fees, especially in sideways markets where holding the asset alone would yield no returns.
đ° Maximizing Profitability: Why Choose Liquidity Pools?
The speaker discusses why liquidity providers might choose to participate in liquidity pools despite the downside risks. They highlight that the fees earned as a liquidity provider can significantly outweigh the benefits of simply holding an asset, especially when the market is stable. For example, holding ETH might yield no profit over a month if its price doesn't change, but being in an LP position could generate 10% or more in fees during the same period.
đ Hedging Risks in Liquidity Pools
The speaker delves into strategies for hedging the downside risks associated with the concave payoff of being a liquidity provider. They discuss the importance of eliminating Delta riskâdirectional riskâso that the provider is only exposed to earning fees. This involves transforming the concave payoff structure into one where the primary concern is only the potential for moving out of range to the upside.
đ How to Achieve a Delta-Hedged Position
The speaker explains a strategy for creating a Delta-hedged or Delta-neutral position using a method developed by Overnight Finance. This involves borrowing a volatile asset like ETH against a stable asset, which creates a short position. By pairing the borrowed ETH with stable assets in an LP position, the speaker explains how this setup allows the LP to be hedged against price declines, as both the LP position and the debt decrease in value, balancing out the risk.
đ Managing Upside Risk in Delta-Hedged Positions
In this section, the speaker addresses how to manage the risk of large upside moves when using a Delta-hedged strategy. They emphasize the importance of daily rebalancing the hedge to avoid liquidation. The speaker suggests keeping a reserve of collateral assets or actively managing the hedge to maintain a Health Factor of 1.2 or above, following the successful approach used by Overnight Finance. This ensures that the position remains stable and profitable despite market fluctuations.
Mindmap
Keywords
đĄHedging
đĄLiquidity Pool (LP)
đĄNonlinear Payoff
đĄDelta Neutral
đĄConcave Payoff
đĄStablecoin
đĄBorrowing
đĄYield
đĄRebasing
đĄHealth Factor
Highlights
Introduction to hedging and liquidity pools, explaining the difference between linear and nonlinear payoffs.
Explanation of the concave or negatively convex payoff when providing liquidity compared to holding an asset spot.
Clarification that liquidity providers lose more to the downside and gain less to the upside compared to holding the asset.
Discussion on the profitability of providing liquidity due to passive income from fees, despite the nonlinear payoff.
Illustration of how holding ETH while it moves sideways results in no gain, but providing liquidity can generate significant fees.
Introduction to the concept of hedging downside risk in a liquidity provider (LP) position to eliminate Delta risk.
Description of a strategy to hedge downside risk by borrowing a volatile asset against a stablecoin.
Explanation of how borrowing against a stablecoin creates a classic short position, profiting from a decline in the borrowed asset's value.
Step-by-step guide on pairing borrowed ETH with stablecoins to create an LP position that is Delta hedged.
Clarification that in this Delta hedged position, a decline in ETH's value reduces both the LP position's value and the debt value, balancing the loss.
Identification of the risk to the upside in a Delta hedged position, where both the LP position's value and the debt value increase.
Introduction to strategies for protecting against significant upside moves, including daily rebalancing of the hedge.
Discussion on maintaining a 1.2 Health Factor to avoid liquidation, as practiced by Overnight Finance.
Explanation of how Overnight Finance keeps a reserve of collateral assets as a precaution against large spikes to the upside.
Conclusion on creating a Delta hedged or Delta neutral position to manage risk in liquidity provision.
Transcripts
yeah so I want to talk a little bit
about hedging and a little bit about how
uh liquidity pools work just a high
level overview so we have nonlinear
payoffs as liquidity providers now what
does that mean well a linear payoff is
this so if I'm holding an asset spot
I've got a linear payoff here but if I
deploy that same asset into a liquidity
pool I have this concave or negatively
convex payoff this is a nonlinear payoff
and so what does that mean well it means
that I lose a little bit more to the
downside in the lp position than I would
if I was just holding that asset spot
and I make a little bit less to the
upside if I'm in the lp position versus
if I was just holding that asset spot so
you might be thinking to yourself if you
lose more to the downside and you make
less to the upside why in the world
would you provide liquidity at all well
because of the fees so that passive
income those fees can greatly outweigh
just holding an asset spot so think
about it this way if I'm holding eth and
eth moves sideways for a month if I'm
just holding it I've made nothing but if
I'm in an LP position I could have 10%
or more in fees over that same 30-day
period so that's why it can be
incredibly profitable to be an LP but
how do we make sure that we can hedge
ourselves a little bit here because look
you got this concave payoff as an LP so
to the downside how do you hedge this
downside risk and how can you turn this
concave payoff how can you make it such
that you have eliminated your Delta risk
you have eliminated your directional
risk and now you're just in their
earning fees how do you do that well you
want to get to something like this where
you've hedged your downside and your
risk at that point is just going out of
range to the upside so how do you
generate something like this well the
guys over at overnight Finance Lucas
they've done a really good job at
describing this strategy and so what you
do with this diagram here what you do is
you take a stable you lend it on a or
moonwell or wherever and then you borrow
eth or a volatile asset against it and
that act of borrowing against a stable
the act of borrowing is a classic short
position now why is it short well if I
borrow an asset I profit if it declines
in value because then I can buy it back
for Less so that spread that's your
profit it's a classic short position and
if I take that borrowed eth and I pair
it with own Stables to create an LP
position and I'm earning yield on this
LP position where half of my capital is
borrowed e then I'm Delta hedged I'm
Delta hedged in this position so to the
downside if e declines then the value of
my LP position declines but so does the
value of my debt so that equals it you
know that that's your hedge right there
now to the upside if the value of my LP
position increases well so does the
value of my debt so what I've got to
worry about here is a big move to the
upside and so how do I protect against
that well I've got a daily rebase my
hedge I've got to make sure that I don't
get liquidated on this hedge and so I've
got a couple of ways to go about doing
that I can like overnight Finance does I
can keep a res reserve of collateral
Assets in case there's a huge Spike to
the upside or I can just be a little bit
more active in rebasing my pedge and
keep it at or above a 1.2 Health Factor
yeah this is I'm just going based on
what ovn does and they've been so
successful with this strategy so I'm
just saying hey 1.2 that's the limit I
want to keep it above a 1.2 nice and
yeah this is how you would create a
delta hedged or delta neutral position
what's
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