DeFi is hot but also perilous. How to hedge against risks?


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DeFi users can borrow market indicators and derivatives to obtain revenue while ensuring transaction security.

Original title: “DeFi 丨 The market is so hot, how to hedge risks? 》
Written by: Jarvis
Translation: Li Hanbo

DeFi users are like lobsters in boiling water.

As prices fall, their capital is on the verge of liquidation, and most people do not realize this .

If prices continue to fall against the trend in the next few weeks, we will likely witness the liquidation avalanche of DeFi. This will teach new DeFi users the first lesson in the risks of DeFi.

As of now, DeFi users have not fully realized the risks and leverage used on their locked capital . They are no longer a simple miscellaneous army. Instead, they need to manage their accounts like they manage open positions on margin. This situation is much like a driver of a daily passenger car being asked to enter a Formula One car. The only difference is that DeFi users may not even know that they are sitting in a car .

This puts a large amount of capital at risk of liquidation when prices fall. Created an environment reminiscent of March 2020 for price action. For someone who does not trade, this is sub-optimal. For traders, this creates opportunities.

The reality is that most cryptocurrency users do not have the ability to spot this market trend . The unique thing about DeFi is that it is not on an exchange. There is no order book, and there is no ratio of longs to shorts. Tools to better predict market corrections have just been developed. Because these developments are so new, the first wave of traders who adopt these methods and techniques will be rewarded. This is also the purpose of this article-to show you the opportunities ahead.

Let us observe the state of the market through the perspective of DeFi, what it means for price action, and how traders can profit from this setting.

DeFi market status

In the past thirty days, nearly 2.5 million ETH and 50,000 BTC have been added to DeFi. You can see this in the diagram of DeFi Pulse below.

The first graph shows that the ETH locked in DeFi has grown from less than 4.5 million to nearly 7 million. At the time of writing, slightly more than 6 million ETH is locked in the DeFi contract.

The second graph shows the number of BTC locked in DeFi. This is a similar trend. In the past 30 days, nearly 50,000 BTC has been added.

DeFi is hot but also perilous. How to hedge against risks?

This is a significant increase in a short period of time. With the unfolding of this growth, prices have reached their highs during the year.

In fact, in the past thirty days, the average price of Ethereum was $402. The last time ETH was so high was in July 2018. On the other hand, the average price of Bitcoin is about $11,500. The last time I was at these levels was more than a year ago.

When it comes to DeFi, we must understand that when earning a rate of return, in most cases, assets are “locked” in smart contracts , so users can borrow from them. This opportunity allows the borrower to generate a yield higher than the borrowing interest rate, or use the borrowed funds to trade and earn a return higher than the borrowing interest rate.

Collateral is what makes this possible . Therefore, as long as the locked cryptocurrency maintains a value higher than the borrowed amount, everything is easy to handle. The initial value of this locked collateral and borrowing amount is often around 200%. In other words, the value of the locked asset is twice the amount of borrowing.

In other words, it is the risk that users take on their locked encrypted assets. Because as the value of their locked assets decreases-the price of ETH decreases, their mortgage rate also decreases. This is everything discussed in the introduction and where things start to get exciting.

To make it easier to understand, let’s look at an example-if a user deposits 10 ETH at a price of 402 US dollars and the mortgage rate is 200%, he can use it to borrow 2,010 US dollars.

Now, when the ETH price drops from $402 to $300, the ratio is no longer 200%, but 149%. When it reaches about 113%, which is about 2275 USD, the 10 ETH in the DeFi contract can be realized.

According to this calculation method, it will happen when ETH reaches 227 USD. This means that if the price reaches $227/ETH, it is estimated that 2.5 million ETH will be sold in the market .

It is important to remember this.

First, we just went from 490 USD to 310 USD within a few days. Second, liquidation does not start with US$227. That’s just the bottom line of the DeFi contract. In fact, near the peak of $490, assets locked with a 200% mortgage rate have not yet been touched. They won’t start until about $280.

However, we have already seen the liquidation begin.

By querying, you can view the historical and real-time liquidation status on the MakerDAO platform. You will notice a few pages of liquidation on September 5, when the price reached its most recent low.

This is just the tip of the iceberg. If the price enters the price level below $280, traders can expect an avalanche-style forced sell-off as the DeFi contract is cleared on the open market.

The 2.5 million ETH and 50,000 BTC are not necessarily locked in the MakerDAO smart contract, but most of them are. In fact, YETH, as one of the most popular vaults, is in the top ten list with the largest pool of funds on MakerDAO . The problem is that most users are not aware of this risk.

This is why this avalanche selling is a real risk and sets the stage for aggressive price moments in the coming days and weeks.

How to do

The encryption environment is changing, and new DeFi products are launched every day, attracting a wave of former encryption speculators. In fact, these products are creating a market in which users are no longer just exposed to spot-like leverage, but are using their assets.

It means that the market itself is undergoing a transformation, and more cryptocurrencies are being leveraged . And you may or may not know that more leverage brings more volatility.

A simplified analogy is the car engine. As you increase horsepower and start adding modifications, it will move faster from point A to point B, but at the same time, faster speed brings more risks. As the speed increases, small bumps or slippery road surfaces can cause fatal collisions. In a market where every dollar of change in ETH and BTC can generate more returns, the risk of these fatal car accidents will become greater.

One day’s price fluctuation is no longer just a bad day, it may mean permanent loss of capital. This is why security issues must be considered.

Therefore, how can traders stay ahead in this changing environment? In other words, how to improve the security of transactions in DeFi while exceeding the revenue?

Use more market indicators and tools

The indicators that most traders are accustomed to will no longer be so reliable. The transaction volume and transaction activity on the DeFi platform is increasing day by day. Liquidity levels, leveraged positions, and rates of return are not just controlled by the largest centralized exchanges.

This also means that the flow of cryptocurrency in and out of the exchange can no longer fully reflect the pressure of buying or selling assets. Therefore, traders need to accept some tools. These tools can view the trading volume of DEX, the rate of return of various assets, the liquidation level of various DeFi smart contracts, and even the mempool of the network–the last tool is unique in that, Rising unconfirmed transaction volume or network congestion may lead to more serious price corrections.

Embrace derivatives

As volatility increases, new opportunities also follow. This is a trader’s dream. Because if prices go up and down more frequently, there will be more opportunities for profit. Conversely, the increase in price volatility means that traders have an increased chance of losing positions on a good entry. When this happens, it is a frustrating experience.

This is why many traders use option leverage. They allow traders to take advantage of this volatility while ensuring that they will not be knocked out at a good time of entry. This is a simple way to increase the chance of a successful transaction.

In addition, options are not unique to traders. DeFi users need to embrace them as they explore DeFi opportunities. This is a way of hedging losses.

For example, if a new project promises an ETH return rate of more than 200%, users can “buy insurance” for their capital through a bearish contract. This allows DeFi users to make up for potential losses in liquidation events they may suffer. Of course, this may reduce the rate of return by a few percentage points, but it allows DeFi income farmers to explore riskier projects and safely allocate more capital to DeFi.

for example:

If a DeFi user borrows 100 ETH at a price of 402 US dollars (collateralization rate is 200%), and is expected to have a capital loss of 13%, then the user can buy a bearish contract. For every contract purchased at a price of $402, if the price moves to a clearing mark near $300, they will get a value of at least $102. This in turn allows them to get about 0.33 ETH for every contract they buy.

When the volatility is low, the cost of a put contract (measured by IV-implied volatility) close to the “capital” is about 0.1 ETH, and the expiration date is two months. This means that the profit per put contract is 0.23 ETH.

For individuals, their 100 ETH capital may lose 13 ETH, and they can hedge this loss. If they buy 5 ETH put contracts at a price of 0.1 ETH per contract, and the price drops from $402 to $300, then their put contracts are essentially worth 0.23 ETH each. And 5 ETH worth of contracts are equivalent to 50 contracts, which means that there may be a profit of 11.5 ETH. This can almost offset the loss caused by DeFi liquidation.

This small plan highlights the importance of risk management in DeFi and how to hedge during the rotation of returns .

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