Delta-neutral crypto strategies
Delta is a risk metric which measures the sensitivity of the derivative value with respect to changes in the price of the underlying asset. Delta-neutral means that a trading position has zero delta, which is another way of saying that the position (or portfolio) is not sensitive to the change in the underlying asset’s price. Though not totally fail-proof, it is a great way of minimizing market risk by decreasing the exposure of the portfolio to the market.
Given crypto is a highly volatile market, delta-neutral strategies should be a part of one’s portfolio. In the market where many assets can lose 90% of their value in days, you have to limit your exposure to the price risk by allocating part of your portfolio to delta-neutral strategies. We can specify several such strategies below.
Yield farming with stablecoins. There is a risk of impermanent loss in regular yield farming since price(s) of either token can change. Stablecoin farming minimizes this risk. You receive interest for providing liquidity to a pool while your risk is capped because you hold stable assets which have almost no exposure to market fluctuations. But stablecoins are not without risks about which we write below.
Leveraged yield farming (LYF) with stablecoin. LYF is what its name suggests. It’s the yield farming that uses leverage. LYF allows you to borrow and farm those tokens too to increase your return. Say, you put 1,000 USDC into a yield farming protocol. If you want to do yield farming with only your 1,000 USDC, this means 1X leverage. If you borrow 1,000 USDC and put that amount to work, it means you use 2X leverage. Borrowing twice the amount that you put originally is 3X leverage and so on.
LYF is capital-efficient which means that you can borrow more than you put up. This can strengthen your yield farming positions. As of this writing, 1X (that’s standard yield farming) yield farming on BUSD/USDT on Kalmar, a protocol built on Binance Smart Chain gives only 18.76% APY.
But if you choose the maximum possible 6.5X leverage, you’ll get 82.35% APY!
Leveraged stablecoin farming yields seem delicious, especially during crypto winter. It is certainly a good way to minimize your exposure to market swings. But don’t forget that stablecoins, too, can and do deviate from their pegs. In 2022 May we saw the spectacular failure of the Terra blockchain network which sent the price of its stablecoin UST to 0. Well, almost zero. Speaking of more recent events, USDC depeg after SVB default can be mentioned.
Funding rate arbitrage. To understand funding rates, we should first introduce perpetuals. Perpetual futures are like traditional futures with one important difference: they don’t have an expiration date. You can hold your position without thinking about maturity date and delivery. That perpetuals don’t expire means that there should be a mechanism ensuring that perpetuals prices won’t diverge from the prices of underlying assets. This is where funding rate enters the play. Funding rate helps perpetual price converge to the price of the underlying asset.
The prices of a perpetual contract and of the underlying asset are called mark and index respectively. If the perpetual is trading at a premium to the index (i.e., perpetual price is higher than the underlying asset price), to hold the perpetual is better than to hold the coin itself. That’s why longs will pay short an amount that corresponds to the divergence of the mark from the index. This is also called a positive funding rate. Conversely, a negative positive rate is something that shorts owe longs. This happens when the mark is trading lower than the index.
Funding rates are determined by the market. If traders are more inclined to be leveraged on the long side, which is usually what happens in a bull market, then there will be a demand for buying the perpetual contract. This implies that the mark (perpetual’s price) will trade at a premium to the index (the underlying asset price) which causes the funding rate to be positive. Conversely, the demand to be leveraged short will cause the perpetual to trade at a discount to the underlying asset. Thus, the funding rate will be negative.
Let’s say, ETH price is $1,700 while ETH-PERP is trading at $1,710 currently. The perpetual is trading at a discount the index which means that there is a positive funding rate of 0.59%. ( (1710-1700) / 1700. If the dislocation of the mark from index price lasts too long, the arbitrageurs can exploit it by taking opposite positions in the perpetual and the underlying asset. In this example, a trader could short ETH-PERP and buy ETH. The sell pressure on the overvalued (expensive) asset and the buy pressure on the undervalued (cheap) asset will cause the prices to converge. Thus, the trader will earn the funding rate on (almost) the risk-free trade.
Leveraged delta-neutral yield farming. An example will clarify how leveraged delta-neutral yield farming works. Say, you want to do delta-neutral farming with SOL-USDC pair. First, you deposit $1,000 SOL, and borrow $2,000 USDC which means you have a 3X leverage. You’ll be farming SOL-USDC with $1,500 SOL and $1,500 USDC; thus, you’ll be long $1,500 SOL.
Then, you’ll deposit $3,000 USDC and borrow $6,000 SOL, $1,500 of which will be swapped to USDC. You’ll be farming with $4,500 SOL and $4,500 USDC, and you’ll short $1,500 SOL. Your long and short SOL positions will cancel out, and you’ll be earning return on your $4,000 ($1,000 + $3,000 that you have deposited) which is near neutral.
Spot-future arbitrage. Cash and carry trade, which is a spot-futures arbitrage, was described in my another article (https://www.publish0x.com/bringing-us-treasurys-onto-the-chain/carry-trading-in-crypto-xxzqdly). When there’s contango in the term structure of futures contracts, deferred month contracts are trading at a premium to spot price. But as the futures contract approaches expiry, its price tends to converge to the spot price. One can buy the asset at spot market and simultaneously short the futures, pocketing the delta-neutral difference.
Futures contracts can have a backwardated term structure as well. For example, before Ethereum Merge event many ETH investors shorted futures to hedge their ETH holdings. This resulted in ETH futures trading at a discount to ETH spot price (which is the definition backwardation). You could buy ETH futures and short ETH spot market.
So, when the term structure of futures contracts is in contango, an investor can pocket delta-neutral profit by going long the asset at spot market and shorting the futures at the same time. Conversely, when the term structure is backwardated, the way to make profit is buy the futures and short the spot market. But note that contango is better for cash and carry trades because shorting the asset at spot market incurs “borrow fee”, which can significantly reduce the profit. Also, not all digital assets are shortable at spot market which makes backwardation less friendly for spot-futures arbitrage trading. Other risks you should be aware of before deciding to do cash and carry trading include:
- Execution risk. If two legs of the trade are executed at different times, this could result in less profit or even in loss.
- Liquidation risk. Too high leverage can lead to the liquidation of the futures contract.
- Trader can experience unrealized loss if the term structure changes.
Maximum extractable value. Maximum extractable value or Miner Extractable Value (MEV) can be defined any automated interaction executed on blockchain which is done to exploit inefficiency and has positive expected value. Though it is challenging to specify where MEV strategies belong to, it is not incorrect to talk about them in the article about delta neutral trading strategies.
Conceptually it is the same thing as high frequency trading in the traditional markets. These strategies typically involve pending transactions in the mempool. The most popular MEV strategies are sandwich attacks and liquidations.
Sandwiches are perhaps the most infamous type of MEV. They are considered negative externalities and are frowned upon by the community. As already mentioned above, they are like high frequency trading in equity markets in that they front-run transaction that are pending in the mempool. Let’s say, there is an order to buy 1,000 ETH on a decentralized exchange (DEX). We can safely assume that this order will rise the price of ETH. What a sandwich attacker would do is this. First, he places an ETH buy order before your transaction. Thus, he front-runs your purchase order. Then, once your buy order is executed, he (or actually his bot) places an order to sell ETH. He buys ETH before you anticipating an increase in ETH price and then closes his position selling ETH at a higher price.
Delta neutral strategies are a good solution to decrease market risk in DeFi. By investing in them, users can reduce their exposure to the volatile crypto market. They can be as diverse as leveraged stablecoin farming, funding rate arbitrage, spot-futures arbitrage or MEV strategies. Considering that digital assets are a new asset class, there is a lot of inefficiency in the market which can be exploited with delta neutral strategies while limiting your exposure to wild market swings. Especially during crypto winter (the name for bear market in crypto) these strategies are an invaluable tool in one’s portfolio. They are uncorrelated with neither Bitcoin nor altcoins nor NFTs, and as such, they can outperform decentralized and even traditional markets during hard times.