delta neutral strategies

This article aims to provide an overview of how to reduce DeFi price risk with delta neutral strategies. If you are unfamiliar with these concepts, do read our introductory articles on cryptocurrency, DeFi, and DeFi price risk before reading this article.

What Are Delta Neutral Strategies?

In a highly volatile landscape, investors might opt to engage in low-risk strategies which will still provide them with returns. A basket of strategies that investors often partake in is delta neutral strategies. 

Delta refers to the theoretical estimate of the extent of change in the value of a derivative with respect to a $1 price change in its underlying asset. A derivative is an investment instrument, such as a stock option, that derives its value from the performance of its underlying assets. The phrase “delta neutral” describes a portfolio that utilizes multiple positions to balance positive and negative deltas such that the overall delta of the assets equals zero. 

In essence, a delta neutral strategy seeks to minimize a portfolio’s exposure to price volatility, mitigating its response to market movements. This article discusses four delta neutral strategies retail investors can consider when it comes to crypto: spot-futures arbitrage, spot-perpetuals funding arbitrage, stablecoin farming, and delta neutral yield farming.

Learn more about delta neutral strategies in our Insights piece here!

Stablecoin Farming

Stablecoin farming is similar to regular yield farming, except that the two assets deposited in the liquidity pool are stablecoins, allowing for close to no impermanent loss from this position. By being pegged to the same underlying asset, fiat currency in most cases, users can earn yield simply by holding an asset that is resistant to market fluctuations. This is why stablecoins have become a linchpin in the DeFi stack and why stablecoin farming is such a popular strategy among investors. In theory, investors that engage in stablecoin farming are only exposed to idiosyncratic risk.

Stablecoin Leveraged Farming

Usually, stablecoin pools offer annual percentage yields (APYs) from 8% onwards. To optimize yield, users can opt to leverage farm stablecoins as well. While leverage farming with volatile assets might be risky, stablecoin leveraged farming is inherently less risky due to the lack of price action of stablecoins.

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

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

For a 6× leveraged position, an investor has to borrow 5000 BUSD on top of the principal amount of 1000 BUSD. Next, he will convert this borrowed amount to 2000 BUSD and 3000 USDT to fulfill the requirements of participating in a stablecoin liquidity pool.

Hence, the investor will deposit 3000 BUSD and 3000 USDT, worth US$6,000, with the potential of earning 6× the yield compared to if he had only farmed with the principal amount of 500 BUSD and 500 USDT. 

All-In Stablecoin Leverage Farming?

While leverage farming on stablecoins might seem like an attractive investment during bearish 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, which is backed by a large reserve of assets and is verified by attestation reports published on a regular basis, is probably less risky than an algorithmic stablecoin. Although pairing algorithmic stablecoins with fiat-backed stablecoins might offer much higher yields, it comes with the risk of higher exposure to impermanent loss since algorithmic stablecoins can deviate from their peg. In the worst-case scenario, the algorithmic stablecoin could completely lose its peg like the infamous UST.

Read our Insights piece about stablecoins “The Evolution of Stablecoins: A Vital Cog in DeFi”.

Spot-Futures Arbitrage

Another popular way to generate delta neutral returns is through arbitraging the spread or difference between the spot market and the futures market. Futures are typically priced at a premium or discount to the underlying market due to several factors like opportunity cost on capital.

For example, leading up to the Ethereum Merge, futures on ETH expiring on 30 September 2022 exhibited a discount north of 2%. This is due to investors shorting futures to hedge their spot ETH positions. Assuming that the spread would converge upon expiration (i.e., spot price of ETH will be equal to futures price of ETH on 30 September 2022), investors sought to capture the spread by shorting the spot market and going long on the ETH futures.

Figure 2 represents the payoff when the example trade is executed. When both spot and futures prices converge upon expiration, the trader can net a delta neutral profit of $20.

While this strategy allows 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, shorting the spot market incurs a “borrow fee”, which can eat into potential spread profits or even turn the trade into a loss. Furthermore, execution risk could be a problem if the trades are not executed “atomically”, where each leg of the trade is done on a separate timestamp. This could result in a slight difference in the entry price of each leg.

Spot-Perps Funding Rate Arbitrage

Frequent users of perpetuals, or perps, will notice that the instrument has a funding rate applied to the open position. Funding rates are periodic payments used to pay traders that are long or short based on the perps and spot prices. Unlike futures, which automatically reflect in-kind funding costs through term structures, perps impose an 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 on the perps contract pay a funding fee to the opposing side (short traders). In a bearish market, the funding rate is negative, and traders who are short will 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 earn funding fees from this strategy. For example, a trader can short ETH-PERP position using perps, and concurrently buy ETH-USD on the spot market of an equivalent value to hedge against price volatility while collecting funding fees.

An example of a spot-perps trade:

  1. Assuming the funding rate on ETH-PERP is 0.01% every 8 hours
  2. Long traders have to pay the short traders to keep their position open
  3. A trader can short ETH-PERP and long the corresponding amount of ETH-USD on the spot market
  4. The trader can keep the position open as long as the funding rate remains above the desired threshold for the profit to be meaningful

Learn more about basic trading strategies in our Learn DeFi piece, “Introducing Price Risk and Basic Trading Strategies”.

Delta Neutral Yield Farming

Yield farming is a method for investors to generate rewards with their crypto holdings, making their assets work for them rather than sitting idly in their wallets. Similar to staking, users deposit their tokens into a certain protocol 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 engage in this strategy if they do not wish to bet on an asset moving in a particular direction. Instead, they construct their portfolio to be balanced in terms of long and short positions. There are protocols available that allow users to use such strategies. One example would be Francium, a DeFi yield strategy platform that allows users to engage in delta netural farming of LP pairs.

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

Check out our guide on how to do your own research (DYOR).

Delta Neutral Strategies: Risk-Free?

Delta neutral strategies are just one of many ways to hedge against market volatility. While such a strategy is less risky, it does not mean that there is zero risk. It is important to note that the underlying assets have risks associated with them as well. As mentioned, 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 conduct due diligence.

At Treehouse, we want to empower people to navigate DeFi confidently, and this includes helping users with understanding and assessing risk properly. In case you missed it, check out our recommended list of risk-related pieces! 

  1. How to Make Sense of 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. Introducing Price Risk and Basic Trading Strategies
  6. Flash Loans and Flash Loan 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
Disclaimer

This publication is provided for informational and entertainment purposes only. Nothing contained in this publication constitutes financial advice, trading advice, or any other advice, nor does it constitute an offer to buy or sell securities or any other assets or participate in any particular trading strategy. This publication does not take into account your personal investment objectives, financial situation, or needs. Treehouse does not warrant that the information provided in this publication is up to date or accurate.

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