Hedging Uniswap V3 positions using options
In this article we will look at how you can hedge Uniswap positions using options.
Introductory terms:
Underlying asset is the asset in question, in our case a token
Hedge – means protecting yourself from risk. When a user holds a risky asset (for example, ether, an open position on a uniswap, etc.), the value of his portfolio depends on the price of the asset. To hedge a position means to make the position less dependent on the risk factor (in this case, the price of the asset)
A small retreat
In my telegram channel I share even more useful content in the field of decentralized finance: https://t.me/kirrya_achieves
Uniswap V3 position
Let's remember how Uniswap V3 works. Liquidity providers set the desired price range in which their provided tokens will be used, receiving swap fees. The narrower the range, the more commissions she will earn on each swap. However, if the range is narrow, the price will move out of it faster, and the position will no longer earn anything.
When someone exchanges one token for another, for example, USDC for WETH, the pool becomes more dollars and less ether. That is, the number of assets that have risen in price has become less, and the number of assets that have fallen in price has become larger, and so on in each Uniswap V3 position that was active at the time of the swap. Accordingly, the total portfolio value of the liquidity provider has changed.
Liquidity provider risk profile
Let's look at how the cost of a liquidity provider's position depends on the price of ether:
What is the problem with this position?
The problem is that if the price goes down, the liquidity provider will record more and more losses. At first, due to the curvature of the Uniswap V3 position (while the price is in the range), the loss will not be so strong, but as the price moves down, the loss will increase more and more.
This means that The liquidity provider has an open risk on the price of the underlying asset.
What can be done?
You can buy an option, and thanks to it the liquidity provider will not be so dependent on the price of the underlying asset.
What is an option?
Option is a contract that gives the right (but not the obligation) to buy/sell an underlying asset at a predetermined point in time at a predetermined price.
The important thing here is that the buyer has a right, but not an obligation. That is, at the time of expiration (expiration) of the option, he may not exercise this option. For example, if this option is unprofitable for him.
In this article we will consider only European options, that is, those that can be executed only at the moment of expiration of the option itself.
Options come in two types: the first type gives the right to buy, the second type gives the right to sell (at a fixed point in time at a fixed price).
In our case, in order to hedge the liquidity provider, we need an option that gives the right to sell (Put option)
How to calculate the payout for an option
Payout – how much we will earn/lose if we buy this option.
The payout for a European put option at expiration is determined by the formula:
The payout, depending on the price at the time the option is exercised, will look like this:
What's remarkable here?
Such an option gives a positive payout when the price of the underlying asset falls, and in the position we are considering, Uniswap V3, we lose money when the price moves down.
Therefore, let’s “buy” such an option, that is, add two charts and see what happens:
In the example above, we bought not one option, but 1.8 so that the total Uniswap V3 position and option would give a near-horizontal chart.
Important:
In this example, the option value was taken “at random”, purely to show how hedging with an option works.
The stronger the purchased option is “in the money”, the higher its purchase cost will be (it is logical, because if at an ether price of 1500 the option gives the right to buy at 1200, then it should not be cheap)
Is it possible to fully hedge a Uniswap V3 position?
The answer is yes. You can select a put option with such a strike and expiration that it hedges the Uniswap V3 position with very good accuracy. Typically this should be an option with a longer expiration.
That is, we must buy a Put option with a later expiration, hold this option for some time and then sell it. Then the option curvature will be close to the Uniswap V3 position.
Will a fully hedged Uniswap V3 position be profitable?
Detailed analysis shows that in most cases, Uniswap V3 position fees cannot offset the cost of the option. But not always. However, options can be seen as a good way to hedge risks (for example, buy a cheap out-of-the-money option for pennies, greatly limiting your losses)
I hope that the article was interesting and useful for you. I'll be glad to read your comments
