Whether as accredited investors or as retail participants, most of us tend to only look at the potential upside when purchasing stocks and cryptocurrencies. As long as everything is going smoothly and the price goes up, then we all get a little bit richer, at least on paper. However, as long as those profits are unrealized, our assets will be left to the whim of the market. When the pullbacks come, which tend to happen much more frequently in the crypto space, most if not all of your gains could be easily wiped out, and then some.
But what if you could reduce your losses or even protect the gains that you’ve made so far? Well, there are multiple ways to do that, but collectively they are all known as hedging. Hedging is an incredibly useful method for mitigating the risk of unfavorable price movements, either by capping your profits or your losses. In other words, your potential gains may be reduced via hedging, but you could also limit your downside if things go south.
Hedging can be achieved in a variety of ways, notably by investing in instruments or assets that are correlated to your current holdings but in the opposing position. This can be achieved through diversification, options, futures, and perpetual contracts. In this article, we will be taking a closer look at these different strategies and their subtle differences. Also, we will see how these instruments have evolved into more than just an insurance policy but also a tool for generating yield, regardless of how the market moves.
Hedging Strategies
While hedging itself can be very helpful for mitigating risk, it is not a risk-free endeavor in and of itself. As we’ve mentioned previously, there are various tools and portfolio-building techniques, but usually, it comes at the cost of additional investment or forgoing extra gains. Each strategy has its pros and cons, with some being more effective based on the size of your portfolio or how the assets have been allocated.
Below are some of the more common ways to perform hedging strategies, which previously were only available to heavyweight investors in the realm of traditional finance. But now, with the growing popularity of DeFi, any retail investor can get access to these financial tools in a completely decentralized manner.
Diversification
If puts, calls, and other financial products are a little too complex for you at the moment, there are far simpler forms of hedging, such as diversification, which is also the most accessible hedging strategy for smaller investors. Simply put, the old adage of not putting all your eggs in one basket rings true here, as you can diversify your portfolio in such a way that certain assets will offset the risk of your other investments and vice versa.
While investing in various asset classes can be costly due to minimum purchase requirements and administrative fees, the rise of decentralized synthetic assets or ‘synths’ has made it much easier for retail investors (and crypto purists) to get in on the action. These derivatives, issued by Mirror Protocol and Synthetix, emulate the price movements of the actual underlying asset and can be purchased in tiny fractions through decentralized exchanges. Some of the assets that are on offer include large-cap stocks such as Twitter and Apple and even precious metals.
A prime example of diversification in action was during the recent political turmoil in February earlier this year. While riskier assets like stocks and some major cryptocurrencies plummeted upon the news, precious metals such as gold and silver surged in price, highlighting the increased demand for safer assets in expectation of tumultuous times ahead.
Stocks vs. Gold & Silver (Source: Longtermtrends)
By allocating your portfolio towards different asset classes that are weakly correlated, or even inversely correlated with each other, you are able to capitalize on trends that are inherent to each asset class. For instance, if you were to hold some safer assets as opposed to adopting a purely risk-on approach, during a downturn the relative stability of these safe assets would help mitigate some of the losses you would have faced if you had a portfolio of purely risk-on assets. However, there is also no guarantee that these assets will all move in different directions, and they could all just go down simultaneously.
Options
While diversification is a more straightforward concept for most investors to understand, it is often difficult to quantify exactly how well your risk exposures are hedged. For a more quantifiable approach to hedging, certain derivatives, such as options, are more preferable. These instruments derive their value based on an underlying asset, and because of that, their value will certainly fluctuate based on the price movement of its related asset.
For the uninitiated, options allow users to buy or sell an asset at a specific price before or on a predetermined date. “Call options” allow you to buy, while “put options” give you the optionality to sell an asset at a fixed price (called a “strike price”) within a specified period of time. Thanks to popular trading platforms like Robinhood, options have gained notoriety as a cheaper way to obtain leverage without having to buy the actual asset. However, most people are unaware that their main purpose was for risk management.
Payoff of 1 ETH put option (Source: CoinGecko Research)
For a more concrete example, let’s assume that you’ve purchased 10 ETH at $2,500, and after a long period of hodl-ing, your stack is now worth $2,900, appreciating by 16%. Although ETH may reach a new all-time high in the future, you might be concerned that your precious returns could be easily wiped out. To protect yourself, you can purchase ten ETH put options with a strike price of $2,900, with each option costing you $8.65.
From here, we can consider two scenarios - whether ETH stays above $2,900 or below. If the price of ETH remains steady or continues to climb until your options expire, then you would just lose the amount paid for the options, totaling $86.50. But if the price of ETH falls below $2,900 within that period, then you can choose to exercise the options to ensure that your ETH can still be sold for $2,900, or you can sell the options since they are now valuable.
In either case, we can see that for a small cost, options could be used to establish a lower limit to how much you could earn, as well as an upper limit to how much you could lose. (Do note however, these are just simplified calculations and don’t take into account the transaction fees and various other factors that may affect option prices)
Source: Premia
In the crypto space, there are a plethora of different platforms to purchase options, such as Opyn, Deribit, Siren, and Premia. These platforms feature their own list of options to choose from, each with different prices, expiry dates, and fees, so be sure to check them all out if you intend to use options as part of your hedging strategy.
Futures / Perpetuals
Much like options, you could also obtain downside protection via futures or perpetual contracts. The key difference here is that, unlike options, both parties must honor the futures contract upon maturity, whereas option holders need not exercise their option. Futures contracts are standardized agreements to purchase or sell an asset at a predetermined date in the future. On the other hand, as the name implies, perpetual contracts do not have an expiration date.
Using the same example from before, ETH holders can apply the same principle by holding their spot positions while opening a short position at their target price, using either futures or perpetual contracts. Let’s assume that an ETH short position was opened at $2,900. Now, if ETH goes below that value, the profits from your short position will offset the decrease in value of your holdings and vice versa before deducting any fees.
However, using futures or perpetuals as a hedging strategy requires a fair bit of monitoring since you need to maintain the required amount of collateral. Unlike options where you just pay the premium upfront, for futures / perpetuals you have to maintain a minimum amount of collateral to keep the position open, and continue to pay funding rates. If you insist on holding a position that is not going too well, funding rates will slowly eat into your capital, requiring you to top up your account. If you fail to do so, your position will be closed, and you will be liquidated.
ETH perpetual contract terms (Source: FTX)
Besides that, you will also need to keep an eye on expiration dates for futures contracts. If you do not intend to execute the contract, you need to sell it before it matures, or roll over the contract. By rolling a futures contract, you are essentially extending the settlement period by closing the old contract and opening a new one, allowing you to stay protected until the next maturity date.
In either case, these contracts are largely reserved for established cryptocurrencies that are heavily traded on major centralized exchanges. Long-tail assets are harder to hedge this way since their derivatives are generally not supported on most exchanges due to lack of liquidity. Nevertheless, decentralized perpetual platforms, such as dYdX or Drift Protocol, could prove to be a viable solution for derivatives of more exotic assets.
Yield Farming with Delta-neutral Positions
Largely associated with options trading, having a delta neutral position refers to a portfolio of assets that will remain unchanged in value, thanks to offsets from a combination of physical assets as well as their derivatives. In theory, as the price of an asset rises, the value of the corresponding short derivative will reduce by an equal amount, resulting in a net-zero change to the portfolio’s value. However, this does not mean that the portfolio cannot generate yield. A delta-neutral portfolio would still be able to generate returns via changes in the asset’s implied volatility or through time decay.
While these strategies are often employed by professional traders, smaller investors can also use this strategy to protect their unrealized profits. Delta-neutral positions are even used to collateralize algorithmic stablecoins such as UXD. Now with the introduction of synthetic assets and automated strategy vaults, anyone can take advantage of delta-neutral positions to generate yield with relatively low price risk.
The first iteration of these yield-generating strategies was made possible through Mirror Protocol’s Mirrored Assets or mAssets. Users can open a short position on mAssets to earn yield from their short farms. As long as the short position is kept open, users will earn rewards in the form of MIR tokens. However on Mirror, you need to maintain a minimum collateral ratio of 150%, or you will be liquidated. If the price of the borrowed asset goes up, it will cost more for you to repay your loan, and your collateral ratio will also decrease, increasing the possibility of liquidation.
To combat this risk, an equal amount of the shorted mAsset is then purchased at the same price so that your position is now delta neutral - the cost of your debt is fixed and can be repaid safely at any time regardless of price fluctuations, but you still generate returns through this strategy, as long their short position has not been liquidated.
mAsset Long & Short Farms (Source: Mirror Protocol)
Although this strategy doesn’t seem too complicated and is well-suited for newer or more risk-averse investors, it requires a fair bit of monitoring of your collateral ratio, especially for more volatile assets. As with all delta-hedging strategies, you also need to readjust the ratio of assets to short derivatives from time-to-time as the price of the underlying asset changes in order to maintain your hedge. This can be done either by increasing your long position, or paying down your debt to improve your collateral ratio. Ultimately, all of this can be quite tedious as it requires regular monitoring and performing multiple transactions manually, which incurs more fees and will eat into your profits.
For a less cumbersome alternative, Aperture Finance is a new DeFi protocol that allows users to deposit their Terra USD (UST) into vaults where a delta-neutral strategy for different assets is completely automated. All you need to do is to select your collateral ratio, which will affect your expected returns. A lower collateral ratio will result in higher APYs and vice versa, so you can tailor your risk tolerance for each asset individually.
Source: Aperture Finance
Unlike the strategy discussed earlier using Mirror Protocol, the delta-neutral strategy used in Aperture is far more complex than just holding certain tokens while also maintaining a short position. It consists of many layers and involves additional protocols such as Anchor and Spectrum to maximize yields for depositors.
To keep things simple, we can break the strategy down into two parts - the long-farm and the short-farm. In the short-farm, two-thirds of the user’s deposits are used to open a short position on Mirror, similar to the previous strategy. However, instead of using UST directly as collateral, it is first deposited into Anchor to earn interest. The aUST received from Anchor will then be used as collateral on Mirror to short the chosen mAsset. The UST returned from shorting the asset can only be claimed after two weeks.
For the long-farm, the remaining third of the funds are used to purchase the mAsset. After two weeks have elapsed, the UST returned from Mirror will be used in conjunction with the purchased asset to provide liquidity on Terraswap or Astroport, earning trading fees along the way. The LP tokens received are then further staked on Spectrum Protocol to earn MIR and SPEC rewards.
By combining the short position collateralized by interest-bearing assets with the same amount of assets purchased to provide liquidity, the strategy is able to generate greater returns from four different sources instead of just one. But this comes at a higher cost since Aperture also charges a 10% performance fee on your realized gains and requires a minimum deposit of 2,000 UST. Despite that, it seems that Aperture has found its audience, amassing close to $100 million in TVL within a month.
TVL of Aperture Finance since launch (Source: DefiLlama)
Remember we mentioned earlier that delta-hedging strategies need consistent readjustments? Well it’s the same for Aperture. While the asset's price movement will completely offset the short position, this is no longer the case once the long-farm strategy provides liquidity to a Terraswap / Astroport pool. As trades are executed through the liquidity pool, the composition of the pool will change, shifting the balance of assets represented by the LP tokens.
In other words, the amount of mAsset in the long-farm will constantly vary, resulting in a pseudo delta-neutral position instead of an actual delta-neutral position. Thus, to mitigate the risk of the position moving too far into a net long or net short position, Aperture’s smart contracts will automatically rebalance the long-farm if it deviates by more than 3%. For instance, if the shorted amount is $1,000, the rebalancing process will only be executed if the asset value of the long-farm exceeds $1,030 or drops below $970.
With a completely automated strategy, protected by various rebalancing and liquidation mechanisms, Aperture abstracts away the complexities in crafting a delta-neutral strategy. By making use of existing platforms in the Terra ecosystem, these strategies are modular, and can be constructed from protocols that are able to maximize yield for depositors. Besides that, it offers an incredible amount of flexibility for returns, as users can adjust each individual vault’s collateral ratio to match their risk appetite.
Final Thoughts
In this highly volatile space we know as the cryptoverse, the dump can come just as fast as the pump, eliminating your hard-earned gains within a blink of an eye. As such, mastering the art of keeping your profits is just as important as learning how to get them. You don’t need to get too technical or have a large capital base to start hedging. With the power of DeFi, anyone can access and perform different hedging strategies, all on their own.
Furthermore, these strategies need not function merely as protection but also as a way of generating yield for more passive investors. While the protocols mentioned above are primarily on the Terra blockchain, more platforms are now offering automated delta-neutral strategies on a multitude of blockchains. Some examples are Alpaca Finance on the BNB Chain and, more recently, Delta One and Friktion’s Crab Strategy vault on Solana.
As the need for hedging and delta-neutral protocols become increasingly popular with the broader crypto community, we can expect to see a wider range of supported assets. Additionally, the versatility of DeFi’s many ‘Lego pieces’ would potentially allow for more sophisticated hedging strategies to be simplified for the masses. However, this is only the beginning, and there is much more to be done before this nascent space of the crypto industry gets the attention it deserves.
Win Win is an avid gamer, interested in navigating the vast world of NFTs and the cryptoverse. Entering the crypto space in 2020, Win Win focuses particularly on DeFi and GameFi, looking out for the latest developments and projects in the space. The author has lived through the meteoric rise of DeFi as well as the collapse of Terra and FTX. Follow the author on Twitter @0x5uff3r
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