Yield Farming Series – The Linear Hedge

The beauty of yield farming is that it continues to make money as long as people are trading cryptos. The main area we focus on (and there are different kinds of yield farming) is dex farming. That’s where you put two coins on an exchange and when people swap those coins, you get a cut of the fees.

The market can go up, down or in circles and you’ll still make money.

The problem is that during a crypto winter, everyone is looking for a safe haven and every professional investment firm is looking at dex farming too. That means the returns are a lot lower.

What to do?

Welcome to the linear hedge.

AOTB is planning to go Web3 as the AureliusDAO. We’ll roll that out in stages and as the first part of the roll out we’ll use this as part of our yield farming strategy. We’ll explain the basics of the strategy here, and you can go do it yourself. But you’ll find that it’s rather time consuming, so the AureliusDAO will address that.

Subscribers will obviously get a first shot at the DAO membership, but let’s start with the strategy itself.

How Are Returns Lower in A Crypto Winter?

You need to understand the problem that linear hedging solves to understand why it works. The problem is that yield farmers are trying to avoid “impermanent loss” in their farming. That’s a real loss that happens because the price of coins diverge.

Say you are putting ETH and USDC on an exchange. It’s getting 33% APR. That seems great. But this is a crypto winter, so ETH loses half its value. Well, half your pool (the combination of ETH + USDC) just lost half its value.

So, that 33% APR is not looking so great right now. And in fact, because “impermanent loss” actually accelerates losses, you probably didn’t lose 25% of your pool value, but 1/3rd. So, now you have to wait a year just to get back to even.

To avoid that, yield farmers look for pools that only have stable coins–two versions of US dollars for example. Yields from those remain constant as long as the stable coins don’t depeg (and they watch that possibility continuously).

But everyone knows this and it’s already baked into each pools’ yields. Everyone goes to those pools because they’re “safe” and the returns are often below 10% APR. Here’s an example of what I mean from a pool on Aura Finance.

But there is a better solution…

How Does Linear Hedging Help?

What if you could get access to the returns of pools with coins other than stable coins? For example, here’s a pool with staked Matic (stMatic) that’s paired with USDC and has been returning 133% over the past 24 hrs.

Well, you’d worry that MATIC would lose its value in this crypto winter. Fortunately, IndexCoop allows you to buy inverse MATIC.

For every cent MATIC drops, InvMATIC goes up $.01. It’s directly proportional, hence it’s linear. If it went up $.02, then this would be non-linear (ad the math is a lot more complicated).

To keep the math easy, let’s assume this pool would give you “only” 50% APR (the return rate is bound to come down over time). You are going to need to buy 3 positions–say at $10k each.

1. The USDC position at $10k
2. The stMatic Position at $10k
3. And the InvMatic at $10k

We’re ignoring the fact that MATIC and stMATIC aren’t exactly the same. They are close though. With that kind of distribution, you have fully hedged your position. The USDC will be worth about $1 and the InvMATIC will cancel out any drop in stMATIC.

So, you’ve got that 50% APR – 1/3rd of that (spent on your hedge) at 16.66% = 33.33% net APR.

An Improvement

You’re still paying a lot for that hedge. It’s unlikely that stMATIC will drop to 0, so you might not want to hedge all of it. Instead, you might want to plan on a 33% drop.

Remembering that these pools concentrate your declines as prices fall, you’d probably need to hedge about 50% of the pool with InvMATIC. That way, your position is now:

1. USDC at $10k
2. stMATIC at $10k
3. InvMatic at $5k

And your APR just jumped from 33% to 41%+. You will have to watch the prices of MATIC pretty closely though (and yes, I’ve glossed over the fact that we were looking at a concentrated liquidity pool, but I’ve just assumed you know how to keep that in range–it’s not hard. Just check every day).

Concluding Thoughts

Now, of course, you could use options for this. And if you know what you’re doing there, just use perpetuals and set the price decline curve to fit the gamma. If that made no sense to you, then don’t bother.

Linear options work pretty well on their own. All the tools are available and they open the world of yield farming beyond stablecoins. The drawback is that you do need to diligently monitor your pools. If you don’t want a full hedge, then you’ll need to check back more often….which is why we are going to include reward access to yields as part of the AureliusDAO.

With current subscribers getting early access (of course). Still, I’ve just taught everyone how to do this for free.

This week I wrote a number of pieces that are related to this post, so you might want to have a look if you’ve missed them.

That’s it for this week. Remember to join us on Discord if you haven’t already.

Happy Trading!!

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