DeFi liquidity mining market risks are increasing rapidly, how to hedge with options?


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With options and liquidity mining, DeFi users can achieve the highest level of return under controllable risks.

Original title: “Liquid mining, how to hedge risks through options”
Written by: FNX Fans

Since the beginning of September, popular Ethereum and DeFi currencies have fallen sharply , pouring cold water on the market that has just fallen into a frenzy. Many investors involved in liquidity mining have suffered a plunge in locked-up currencies in just a few days , Mining profits have shrunk sharply, and even liquidity market making has suffered a series of losses.

This makes many users who are mining liquidity and many users about to enter the DeFi market hesitant. Public data shows that the total amount of DeFi locked up in the past week has been greatly reduced.

Image source: DeFiPulse Screenshot date: September 14

In the current environment of highly uncertain market prospects, users not only want to participate in the rapid development of the DeFi market, but are also worried about the short-term market collapse risk and sudden losses, want to buy locked currencies but do not know whether the current price is over It is also concerned about whether the rapid rise of the DeFi market will lead to a short run or insufficient capital use efficiency.

In fact, all of these concerns can be solved by option tools. Through options and liquidity mining, DeFi users can achieve the highest level of income under controllable risks.

What are options?

Option, also known as option, is a kind of derivative financial instrument. It is a kind of purchase or sale of a certain amount of the target at a certain time agreed at the beginning of the period at a certain price agreed at the beginning of the period at a certain point in the future. the right option is the traditional leveraged trading in financial markets, improve capital efficiency and one of the most important risk management of derivatives.

To give a simple example, if the user has already performed liquidity mining in the DeFi application, but is worried that the pledged and locked currency such as ETH , LEND, or SNX will plummet.

Then, users can buy put options (PUT) of these currencies, which is equivalent to buying an insurance for their positions, and they can still obtain liquidity mining income when the market plummets, but it will not lead to pledge lock-up. The currency encounters market risks, and at the same time it can obtain unlimited upward returns when the market rises. It also has more advantages than using futures for hedging, as shown in the following figure:

DeFi liquidity mining market risks are increasing rapidly, how to hedge with options?

Advantages of options

DeFi users are very familiar with the operation of hedging with equivalent spot and equivalent futures contracts in the opposite direction . This hedging operation can offset the reverse changes of spot and futures at the same time to protect the changes in two-way price changes. However, this hedging method has a certain risk of high leverage and liquidation , and it will also make users lose a certain one-way trend change.

This risk can be avoided through options . If the user now holds 100 ETH with a unit price of US$380, the user can pay a certain option premium X to buy a (parity) put option with an strike price of US$380.

  1. If the price of ETH falls below $380, the profit of the option and the loss of the spot will offset, at most, the loss of the “premium” of the purchased option.
  2. If the price of ETH rises, the remaining part of the spot price increase after deducting the premium X can be used as profit.

If users are familiar with such option hedging operations, they can also try more advanced gameplay to match their risk appetite and price judgment.

Taking the above picture as an example, if a user thinks that an option with a strike price of $380 is too expensive and wants to buy cheaper “insurance” to hedge, at the same time, it is judged that the price of ETH will not fall sharply, but the probability of an increase will be even greater. Big.

Then users can buy (out-of-the-money) put options with a strike price of 340 yuan or less. This option will provide insurance that the price drops sharply below 340 yuan, while only requiring a lower premium (premium) than X. It is more suitable for users’ personalized hedging needs.

Taking FNX liquidity mining as an example, the current APY annualization is about 540%, the daily income is about 1.5%, and the ETH market price is 380. The user intends to use 100 ETH for liquidity mining to obtain FNX income. With reference to the data of the current ETH option contract, users can buy 100 put options with a strike price of 340 USD for 5 days at a cost of about 0.7 ETH (0.007 ETH*100). The income of mining FNX after 5 days is as follows:

DeFi liquidity mining market risks are increasing rapidly, how to hedge with options?

As you can see from the above figure, once the ETH price drops to 320, the user’s ETH bottom position will lose 16%, but if they have option protection, they will only lose 4% after the mining gains are counted . This kind of profit structure only costs The initial 0.7ETH (US$266) can provide close to 6% loss protection for users’ large positions.

In addition, if the user believes that the market is in a state of turbulence, and will not rise or fall sharply, then they can use more option combinations to gain income or reduce their premiums, such as selling a strike price of 400 US dollars For the (out-of-the-money) call option, the proceeds of selling the call option are used to offset the premium cost of buying the put option. The income return of the spot and option combination is shown in the following figure:

DeFi liquidity mining market risks are increasing rapidly, how to hedge with options?

From the above figure, it can be found that when the user’s expected ETH is within the fluctuation range of 340-400 US dollars, the user can obtain the income of ETH appreciation. Once the price drops by more than 340 yuan, the user can still get the protection of the put option , and the right to sell the call option Gold income can offset the premium cost of buying put options, and this combination is more suitable for users who have a certain ability to predict the ETH market.

With the increase in the depth and breadth of the DeFi market, user transactions, hedging, leverage and other needs will become more diversified and complicated, and financial derivatives such as options will usher in explosive development. Understanding option trading or starting to learn option trading is the general trend of the DeFi market. Decentralized financial derivatives agreements and platforms themselves have become the golden track for the future development of DeFi.

Above, we introduced the basic principles of options and the basic strategies for risk hedging in liquidity mining, including the realization of down insurance by buying put options, and the adjustment of premium fees by buying options with different strike prices. Wait.

However, the actual DeFi and liquid mining market users are more diversified, and the requirements for risk and return structure in actual investment behavior are more complicated. This article will introduce some higher-level strategies and play methods for options in the DeFi and liquid mining market.

The most basic demand of DeFi users is to worry about the risks of staking lock-up currencies, such as ETH, LEND, SNX, etc., but in actual situations, the more general demand is if DeFi users begin to make up their minds to enter liquidity mining , But very nervous about timing.

I am especially worried about buying ETH, LEND or SNX and other currencies at the bottom of the mountain, and I hope to enter the DeFi liquidity mining as soon as possible, so as not to drastically empty the potential market. For such a very typical mentality of opening a position.

How options hedge against liquidity mining risks

Liquidity mining can be combined with a very classic “airbag” (Airbag) option structure. As the name suggests, this airbag structure sacrifices part of the future upside income in exchange for a safe cushion space for opening positions in the early stage.

Take the following figure as an example. If a user purchases this option, he will get a 20% downside protection, but if the option expires, only 78% of the proceeds can be withdrawn, which is equivalent to a potential small portion of the proceeds in exchange for a 20% fall Security protection space, users will lose money only when ETH and other currencies have fallen sharply by more than 20%.

Such airbag options are often traded on margin, and users can use very little funds to obtain a psychologically very comfortable opportunity to open a position, without worrying about a large short run or dips on the mountainside.

DeFi liquidity mining market risks are increasing rapidly, how to hedge with options?

In the world view of options, asset prices are nothing more than a combination of risk dimensions such as direction trends, volatility, and time opportunities . Combining options and liquid mining can achieve buy-in crash insurance based on liquid mining income combined with options , Sell volatility and other strategies.

Keep certain risk dimensions that users want to take, such as price forecasts, and separate undesired risks such as volatility, and create a digital currency “financial product” that has a specific income structure and better meets the purest financial needs of DeFi users. “.

In fact, many of the “structured financial products” that users buy in banks or securities companies on a daily basis are constructed through fixed income + options, and they will be more flexible when mapped to the DeFi market.

The charm of options is much more than that. For example, options can also be combined with liquidity mining to provide structured financial products native to digital currencies .

People can often see structured products linked to gold, stock index, or crude oil prices on bank counters, or some annualized high-yield fixed-income products that provide index enhancements. These structured products also use the principle of options and liquidity mining. The combination of mine and option can also achieve the same effect.

For example, in the liquid mining market, the Snowball option with an automatic redemption structure is provided, and DeFi users can sell an out-of-the-money option with specific trigger conditions.

As can be easily seen from the figure below, through this option structure, users are equivalent to selling an insurance for large investors who want to hedge the spot risk, and charging a fixed insurance fee. As long as the market does not crash, DeFi users can avoid shocks Even in a moderately declining market, a very stable fixed income is obtained. The longer the holding time, the higher the income, just like a snowball, so it is called the snowball option structure.

In addition to the classic snowball strategy, there are many special income structure option strategies that DeFi can learn from. The structured products linked to various major asset structures mentioned above are all through an “American call shark fin” option structure It is constructed and has a high degree of matching with the current hot synthetic assets and many new gameplays.

DeFi liquidity mining market risks are increasing rapidly, how to hedge with options?

There is also a higher-level gameplay that combines liquid mining and options to create native structured products in the DeFi market . The lack of interest-bearing assets has always been the core problem that plagues the DeFi market. At present, in addition to mortgage lending, liquid mining is only one aspect. A new way to provide interest income for the digital currency market, but these ideas are nothing more than the traditional way of generating interest on credit income. Through liquidity mining + options, we can also create a way of “volatility and interest generation”. Convert the high volatility of the digital currency market into an interest income structure.

The Snowball automatic redemption or shark fin structure mentioned above is a typical way. There is also an OBPI strategy (option-based portfolio insurance strategy), the core of which is to invest funds in income assets (liquid mining). And put the obtained income (governance token) into the option, and obtain an upward and relatively safe benefit elasticity through option leverage on top of the basic income.

There are also structures based on increased returns on linked assets and enhanced asymmetric structures (more benefits when rising and less losses when falling). We will reveal the mysterious core of these option structures in subsequent articles.

We can see that the most valuable meaning of option derivatives does not lie in the leveraged trading itself, but in the ability to customize the risk characteristics of assets to cut and recombine . Many high-net-worth clients in the traditional financial market are already accustomed to securities Companies or fund companies customize structured products with higher risk controllable returns based on their own risk preferences and income structure, but asset management companies that provide products often require very high property thresholds for users.

For Franshion’s future DeFi market, at present, users can only accept the degree of leverage speculation on standardized option contracts through centralized exchanges such as Deribit, and are trapped by issues such as market depth, and are far from exploring the true value of open options And charm.

But this also requires the emergence of a competitive decentralized over-the-counter derivatives agreement and market in the DeFi market. Only through the over-the-counter derivatives market can users customize personalized option products and package them through a low-threshold platform. More structured products with creative revenue structures will help DeFi and liquid mining release a broader market space.

Comparing with traditional financial markets, we can see that as of the end of 2019, the global OTC derivatives stock was about 560 trillion U.S. dollars, and the global GDP was only 85-90 trillion U.S. dollars, and the OTC derivatives scale was already a huge amount.

The application prospects of over-the-counter derivatives are very wide, including the creation of structured products (structured deposits, financial management, asset management plans, etc.), products linked to a certain target income; it can also bring leverage, improve the efficiency of capital use, and pass special income The structure realizes the safety point (requirements such as warehouse building and bargaining)

Decentralized over-the-counter derivatives agreements and markets are naturally the jewel in the crown of the DeFi market, a DeFi track with a hundred times the potential of leveraged lending.

We are very pleased to see that projects like FinNexus have begun to run on this golden track and have gained valuable first-mover advantages. Who can take the lead in occupying the leading position of decentralized option derivatives? Who will become the world DeFi? The real giant in the market.

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