In this guide, we’ll show you how you can hedge against impermanent loss when providing liquidity to Perp’s Bitcoin market using Deribit’s newly launched volatility futures product.
Makers (AKA liquidity providers) on Perp can earn trading fees and liquidity mining rewards. However, as the price moves away from your entry point and traders consume the liquidity you provide, you face impermanent loss (or IL for short). But there are ways to hedge described in the article below.
https://blog.perp.fi/how-to-mitigate-impermanent-loss-as-a-maker-on-perp-v2-dce3be4c3514
Alternatively, watch the video version of this article below:
https://www.youtube.com/watch?v=Ns8NwoKe3Yw&t=2s
Since makers are effectively shorting volatility (defined as rapid and unpredictable changes in the price of an asset), the best hedge is a strategy that generates a profit when there’s an increase (rather than a decrease) in volatility.
The article and video linked above describe how to long volatility to hedge the liquidity position. The TL;DR is that makers can use one of two options strategies: straddles or strangles. The payoff curve for the maker is adjusted as a result and when there’s volatility, the gains from the straddle or strangle helps manage the IL.
Payoff of a maker when using a straddle options strategy as a hedge.
While both strategies help to mitigate IL, there are some complexities involved in setting up these options positions: you have to find appropriate strike prices and the premiums may make it expensive to hedge.
Also, the drawback of options is that, as well as volatility, it also exposes you to time decay (known as theta) and the movement in the underlying price of the asset (known as delta). Is there a simpler way? With volatility futures, there is.
What are Volatility Futures?
The best known example of volatility futures comes from traditional finance, with instruments such as the S&P500 VIX. These contracts track the implied volatility (the market’s forecast of volatility in the underlying asset) of the S&P500 index over the next 30 days.
As the market expectations of volatility for the S&P500 index rises, so will the value of the VIX futures. But if the market expects calmer conditions, then the value of the S&P500 VIX futures falls.
To dig deeper into VIX, check out this resource.
DVOL: Volatility Futures for Bitcoin
Deribit recently introduced DVOL futures, which fluctuate in value based on the market’s anticipation of volatile movements in the price of Bitcoin (BTC). These contracts (ticker: BTCDVOL) are traded using USDC as collateral and the price is expressed in terms of the annualized volatility expectation.
For example, if a DVOL futures contract is priced at 60, then it forecasts a 60% move up or down over the next 12 months. We can then calculate the expected daily move as DVOL / square root(365) = ±3.14%. The expected monthly move is equal to DVOL / square root(12) = ±17.3%. Another important feature of DVOL futures is that they have a one-month expiry. Contracts with additional expiries will be added in the future.
To better understand DVOL futures, let’s look at the chart below. The chart displays the DVOL index alongside the price of Bitcoin. When the market is experiencing low volatility, such as during the last few weeks of 2022 and first week of 2023, the DVOL index declines as (shown by the falling orange line).
But as volatile conditions manifested in early 2023, the DVOL index increased sharply in value. Note that the DVOL index is non-directional, it is based only on implied volatility, so it should also rise if there’s a sharp and sudden drop in the BTC price.
This instrument not only helps traders get pure exposure to BTC’s volatility, but it also provides a simpler way to hedge against IL.
Learn more about BTCDVOL in the video below👇
In the following sections, we’ll provide a walkthrough of the strategy, which enables you to earn yield by providing liquidity to the BTC market on Perp while a DVOL futures position can help to mitigate IL.
Strategy Overview
To illustrate the hedging strategy, we’ll start with 3,000 USDC and ~$12 of ETH (around $3,012 in assets).
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1,000 USDC on mainnet Ethereum is required to make a deposit to Deribit. Some ETH (at least $10 worth) will also be needed to cover the gas fees for sending USDC to the exchange.
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2,000 USDC or USDT on the Optimism network to deposit to Perp. To cover the gas fees for managing your positions and claiming Pool Party rewards, $2 of ETH should be enough.
The basic outline of the strategy is as follows:
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Open an LP position on Perp for the BTC-USD market with 5x leverage and a total value of 10,000 USD.
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Go long on Deribit’s BTCDVOL futures with 3x leverage and a position value of 3,000 USD.
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Keep the futures position open until expiry or place a limit order to sell at an appropriate price.
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Monitor the liquidity position and set a price alert for the levels where your liquidity position goes out of range, so you can close the position to prevent incurring further IL.
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The profits from the BTCDVOL futures position should help to outweigh any IL that will be realized after closing the liquidity position.
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If the BTCDVOL side of the strategy incurs a loss, you can roll over the futures contracts and keep the liquidity position open to earn more fees/rewards.
Note: the greater the leverage applied, the higher your risk of liquidation. Ensure you always check the liquidation price of your position using the tools mentioned in the following section.
Setting up a Liquidity Position on Perp
Let’s take a quick look at the first step: how to earn fees and liquidity mining rewards as a maker on Perp. First, navigate to the BTC pool page, click on ‘Add Liquidity’ and then select the ‘Advanced’ option to set a price range.
Assume we expect the price of BTC to fluctuate between $25,500 and $29,500 for the next 30 days or so. These levels are used to set the price range, where 2,000 USDC is used as collateral to open a liquidity position of 10,000 USD.
As long as the price remains within the range you set, you’ll earn a share of the trading fees and be eligible for Pool Party rewards (in other words, OP and PERP tokens!). But if the price goes outside of your range, then you’ll no longer earn any fees or rewards.
Since Perp utilizes the architecture of Uniswap v3, it’s important to understand the concept of concentrated liquidity: the narrower your price range, the greater the share of the fees you can earn. But with a greater potential for earnings comes a larger exposure to IL.
Once you’ve confirmed the transaction, you’ll see something similar to the screenshot below and begin earning trading fees (automatically added to your free collateral).
Using Maker Tools to Set Up a Liquidity Position
Maker tools built by grantees, such as DeFi Lab and PerpSim, can help estimate your potential earnings, the liquidation price of your position and the IL you’ll face at different prices. Using these two maker tools, you can adjust the inputs, such as the price range, the amount of collateral, and the amount of leverage as you see fit.
DeFi Lab’s Perp simulator helps to estimate the IL when the price moves out of range. Select the vBTC-vUSD market, enter the amount of collateral, the price range, and then use the slider to choose your leverage. The simulator visualizes your position, with the shaded area showing where the liquidity position is in range.
Continuing with our example position, the IL is around -$180 to -$217 when the price moves out of range. This is important to note, because it can help to set the size of the BTCDVOL position (as we’ll see in the next section).
For PerpSim (shown below), simply enter your price range, the collateral amount, and the total USD value to see your position on the chart and some backtest results.
Continuing with our example, the backtest shows that the position’s expected earnings are around $725 in the next 30 days if the price remains within the range (shown below by the total fees and Perp rewards in the screenshot below). That translates to a respectable APR of 76%.
However, it's also important to note that the liquidity position would have experienced IL of $608 and has a maximum drawdown of $1,264 according to backtesting.
Once you are happy with the position’s potential earnings and risks, add liquidity to the pool to begin earning USDC. At the same time, a long position using BTCDVOL futures can be opened, insulating yourself from IL while also capturing a share of the trading fees.
Hedging Impermanent Loss with BTCDVOL
Buying the DVOL futures for Bitcoin (BTCDVOL) complements the liquidity position on Perp, reducing the impact of IL so the overall returns are equal or close to the amount of fees and rewards you earn. Both BTCDVOL futures and LP’ing on Perp offer a maximum leverage of 10x.
A prerequisite is to set up an account on Deribit, which is the most liquid crypto options exchange. The drawback is that Deribit is a centralized exchange, so it isn’t universally accessible or pseudonymous.
In the first step, 10,000 USD of liquidity was provided to Perp’s BTC-USD pool, so we now have to buy some BTCDVOL futures here as a hedge.
The question is now ‘how many contracts to buy?’.
Given the complexities of being a liquidity provider (your impermanent position changes as the market price changes) and the fact that BTCDVOL tracks volatility rather than price, selecting a position size requires some guesswork.
To help set a position size, the calculator on Deribit’s order form allows you to simulate different scenarios and see what a position’s profit or loss will be. The PerpSim backtest or DeFi Labs simulation mentioned in the previous section are useful can be used to inform your decision of how many BTCDVOL contracts to buy.
From the historical data, the mean weekly return for the volatility index is ~0.74%, while the standard deviation is approximately 18%. A value of 73.6 is a 1 standard deviation increase from 62, so we can place a limit order to close the long position at this price automatically.
If BTCDVOL rises to 73.6 with a position size of 48.5 contracts, then the profit equals +561 USDC, which is close to the backtested IL from PerpSim (608 USDC). So, in a high volatility scenario, the profit from the BTCDVOL position helps to cancel out the losses from the liquidity position.
Another approach involves setting a limit order to sell at a price of 66.5, which results in a 217 USDC gain. From the previous section, this is equal to the IL incurred if the price goes out of the range to the upside (and exceeds the IL if the price moves below the lower bound of the range).
Let’s say we purchase 3,000 USDC worth of contracts at a price of 62 using 1,000 USDC as collateral (meaning we’re x3 leveraged). That gives us a position of ~48 BTCDVOL futures contracts. Takers are charged a 0.05% fee for a volatility futures position, so opening this position incurs a fee of 1.50 USDC.
After opening the position, you’ll be able to see the amount of DVOL contracts, the value in USDC, the average price, the mark price, estimated liquidation price and the PnL. In this example, the liquidation price is $43.2 per BTCDVOL contract.
We can keep the 3x leveraged position open as long as we’re providing liquidity to the BTC market on Perp. We can also use a limit order to sell at a certain price to exit the position automatically and lock in the profits from the hedge. If the liquidity position no longer earns fees, the position can be closed and the profits from the BTCDVOL position should help balance out the losses.
Remember to set some price alerts so you can close the liquidity position promptly when it goes out of range.
Looking at the BTCDVOL index on TradingView, it has ranged between 48 and 74 in the past month or so. So the position is unlikely to be liquidated, as the price of BTC would have to remain very stable for the index to drive to new lows below 48.
Now we’ve hedged with a volatility futures position, all that’s left now is to sit back and earn USDC from the trading fees generated by Perp’s BTC market! Any USDC you earn is added to your free collateral automatically, and liquidity mining rewards from Perp’s Pool Party can be claimed here each Monday.
As the price of bitcoin fluctuates, you’ll earn a share of the trading fees but also losses from the impermanent position (as shown below).
As volatility increases, the value of the BTCDVOL futures position will generate a profit and, in turn, help to balance out the IL experienced by the maker.
Summary
The advantage of this strategy is its simplicity. You can short volatility by providing liquidity on Perp and simultaneously long volatility using BTCDVOL futures on Deribit. This hedging strategy is much easier to manage as compared to using a straddle or a strangle.
However, the downside is that it’s only viable for BTC at the moment. Volatility futures are not yet available for any other crypto-assets on Deribit, although we will see ETHDVOL futures introduced in the near future. Also, you have to model the strategy around your expectations for the future price path of BTC and the IL you may take on as a maker.
To summarize, there’ll be one of two outcomes for this strategy:
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The price remains within the range of your liquidity position: The BTCDVOL contracts may end up realizing a loss if volatility drops or remains flat. If the index falls to 45, the long volatility side of the strategy results in a loss of $821. But even if BTCDVOL falls, the liquidity position remains in range. And the longer your position is in range, the greater the amount of fees and rewards you can earn.
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Volatility increases, and the price moves out of range: In this case, you can close the liquidity position and settle the remaining position to realize a loss, but the BTCDVOL position should be profitable. You can keep the BTCDVOL position open as long as you think volatility will keep rising or lock in profits at a certain price to negate any losses from providing liquidity.
Some other considerations for this strategy are:
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Using a large amount of leverage for both sides of the strategy increases the liquidation risk. Make sure you have enough collateral, calculate the estimated liquidation prices beforehand and set price alerts for when your liquidity position goes out of range.
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The mark price of BTCDVOL may diverge from the index price and might not converge until the expiry date of the futures contract approaches. That means the futures contract may remain undervalued or overvalued for extended periods of time.
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The initial margin for the volatility futures position is 10% plus 0.00001% of the position size, while the maintenance margin is 5% plus 0.00001% of the position size. Ensure you have enough USDC in your account to cover the maintenance margin. Otherwise your position may be reduced if your account does not meet the requirements.
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BTCDVOL futures were only launched by Deribit recently. At the time of writing, liquidity and trading volume is quite low, meaning it can be more difficult to hedge against larger liquidity positions.
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Instead of entering a futures position on Deribit as soon as you open a liquidity position on Perp, you can set a limit order to buy BTCDVOL when volatility declines and get in at a lower price for a more effective hedge. However, the risk is that the price of BTCDVOL may not reach your limit price and the liquidity position remains unhedged.
As well as hedging a maker’s position, traders that utilize volatility driven techniques (such as Bollinger Bands) can also use BTCDVOL futures to hedge their positions. A more detailed walkthrough of how traders can use this hedging strategy will be shared in a future article.
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We’ll revisit the strategy after the BTCDVOL futures expiry date (April 28th) and share the performance in a follow-up article, so stay tuned to see how much this liquidity position earned in total and how effective the hedge was.
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