How to Mitigate Impermanent Loss as a Maker on Perp v2
An overview of some hedging strategies you can use when providing liquidity as a maker on Perp v2 to mitigate impermanent loss. This article is based on a video presentation by our core developer Nicky Chao, which can be found here.
Being a Maker is Hard
We all know that there’s impermanent loss (IL in the following) for liquidity providers in a pool such as Uniswap v3:
- Suppose you provide liquidity, where 100% which represents the current price on the chart below.
- From the chart, we can see that a 100% price increase translates into a loss of 5.7% for the liquidity provider.
We also have IL on Perp v2:
- If the price goes up, a maker will be forced into a short position, which starts losing money if the price continues to go up.
- If the price goes down, a maker will have a long position, which starts losing money if the price continues to go down.
- So, a maker starts losing money no matter which direction the price goes. 🥲
The IL chart for Perp v2, shown below, is a bit different:
- The liquidity range is current price +/- 50%, where the current price is 0% on the chart below.
- Note that the IL chart will be different depending on the range of a liquidity provider (see the IL calculator).
- If we use 10X leverage, we will lose 100% when the price moves around 36-40%, which means you’ll get liquidated.
How to Hedge IL?
- So we know that the maker loses money whenever the price moves.
- Is there a strategy that earns money whenever the price moves?
Straddle
There’s actually an option strategy, known as a straddle, that earns money whenever the price moves:
- Buy a put and a call option with the same strike price.
- If the price goes up (higher than the strike price), we can execute the call option and earn profit.
- If the price goes down (lower than the strike price), we can execute the put option and earn profit.
- The greater the price movement (no matter what the direction), the more we earn. Some traders use this strategy to bet on the financial statements of a company, since you will not know which way the price will move beforehand, you just know that there will be volatility. Similarly, we can use this same strategy to hedge against IL.
💡 Some exchanges have a wrapper of the straddle strategy, called “MOVE contracts”. However, this kind of product usually has a higher premium, so we only use it if the premium is low enough.
Simulation
Variables and Settings
- Date: 2022/03/19
- ETH market price: around $2,900
- ETH option:
- put & call strike price: $2,900
- premium:
- put: $165.3
- call: $215.4
- expiration date: 2022/04/08 (21 days)
- ETH maker: assume the range is +/- 20% for the maker.
- upper price: $2,900 * 1.2 = $3,480
- lower price: $2,900 / 1.2 = $2,416.6
- maker fee APR: 120% (Please note that this is just an assumption. It is not guaranteed that we can realize this APR for 21 days. The boost from the liquidity mining program helps a lot.)
Steps
- Buy 1.1 ETH put option and 1 ETH call option, the cost should be $165.3 * 1.1 + $215.4 = $395.5.
2. Provide $5,800 USD of liquidity (=1 ETH + $2,900) with a small range of +/- 20% that has an APR ≥ 120%. You will earn $5800 * 1.2 / $365 * 21 = $400.4 after 21 days. Maker fee will cover the premiums paid.
To get the profit of a maker, we add the option profit curve and the IL + Fee curve together, resulting in the profit profile shown below.
3. In the worst case scenario where the price doesn’t move, we will still earn $5. For the optimal outcome where the price moves a lot, we will earn $28 (83% APR without using leverage).
The results are shown here, where this tool is enhanced by our IL calculator. You’ll need to consider the options premiums and the maker APY carefully using this tool to estimate your expected profits.
An Advanced Strategy
An advanced strategy is to use a strangle instead of a straddle, where we buy the call and put options at different strike prices.
What if the maker fee has a lower APR or the option premium is too expensive? For example, the maker fee APR is 60% with a range of +/- 50%. Then the total PnL will be as shown by the chart below.
1. Use a Strangle instead of a Straddle:
- Currently we are actually earning profit from the straddle when the price moves.
- We can give up those profits and just earn maker fees (move the strike prices closer to the average price of a maker position).
Example
If we move the strike price to $2,400 (put) and $3,400 (call), the cost will be reduced from $395.5 to $84.1:
And now we are earning again:
When the price starts moving in either direction, the PnL will fall due to impermanent loss between a +/- 20% price change, as shown by the chart above. But then as the price moves out of your range, the profit from the options strategy will lead to an increasing profit, shown by the rise in the curve above for price changes less than -20% and greater than +20%.
💡 Ideally we should move the strike prices to the average price of our long/short position but there’s no option with the exact same strike prices.
2. Single Side Maker
Experienced traders may be able to sense the price movement so they can actually be a single side maker. This way they only need to hedge one side so they just need to buy one call or put option, generating the same profit as a maker while halving the cost!
If you think the price is going to go up, you can provide liquidity in a range of $2,800 to $4,000 (assuming current price is $2,900) and buy a call option as well. When the price goes down, you’ll have a very small long position. When the price goes up, you’ll have the same IL as the original strategy.
So the IL for an order between $2,800 and $4,000 can be hedged by buying a call option:
Conclusion
- DISCLAIMER: These are just some concepts. Whether we can make profit from these strategies highly depend on maker fee APR and option premium. Calculate everything carefully with the tool before using them.
- It is hard to directly use these strategies to market make on Perp v2 because Deribit only provides BTC and ETH options. Also, other small option exchanges might not have enough liquidity.
