Delta Neutral Stratagem

recent(ish) delta (Δ) neutral vaults, structured products and strategies

Quick Primer on Delta Neutral Positions:

The delta (Δ) is a measure of an option’s risk with respect to the direction of the movement in the underlying contract. A positive delta suggests that there is a desire for upward (bullish) movement, while a negative delta suggests that there is desire for downward (bearish) movement. The delta changes depending on underlying price, time or volatility changes.

A position is delta neutral if the total of all the deltas of the position add up to zero (or in practice minimized to be close to/around 0). For example, if we buy two calls with a delta of 50 each, the delta of the current position is positive 100. If we then sell one underlying contract with a delta of 100, the total delta position is:

(+2 * 50) - (-1 *100) = 0

Having delta neutral position is attractive (in theory), as it allows to hedge against unfavourable price changes and protect profits. This is obviously very exciting for most who are new to options - the concept that you are protected from adverse price movements is extremely attractive. However, in practice delta neutral strategies/positions can be inefficient and costly, especially for smaller portfolios, as numerous transactions are needed to constantly adjust the delta hedge.

Recent(ish) Delta Neutral Strategies:

UXD Protocol:

UXD Protocol is an algorithmic stablecoin, which is fully backed by a delta-neutral position. It’s built on top of derivative DEX’s (i.e. Mango Markets) on Solana, to be able to collateralize the stablecoin.

So, when a user deposits an asset, e.g. 100$ of SOL (for simplicity let’s say in this scenario 1 SOL = 100$) the protocol enters into a short Perpetual Future price. 100 UXD is issued to the user (equivalent to the dollar amount of the deposit).

Note: Perpetual Future’s, unlike regular Future’s Contracts, remove the Expiry Date (perpetual), replace Pre-determined Price with Market Price and removes the need for settlement.

If the price of SOL increases by 1$, the worth of your long position (the SOL that you hold, which you deposited into the protocol) increases by 1$. At the same time, you lose $1 of worth on your short position (the short Perpetual Future opened once you deposited) Therefore, the total change to your position is 0.

The perpetual futures position, which was opened once you deposited assets to redeem UXD, generates yield (depending on market conditions) due to the funding rate of perpetual futures.

Funding rates are a mechanism that ensure that price of assets on the exchange (i.e. a derivative DEX such as Mango Markets) are the same as the oracle price of the asset (actual market price).

For example, if the exchange price is above the oracle price, this suggests that users of the exchange are more interested in buying, which increases the exchange price. If this is the case, and there are more buyers than sellers which leads to a exchange price above the oracle price, the funding rate mechanism fixes this, by ensuring that there is a periodic payment from the more popular position (in this case buying) to the less popular position (in this case selling).

Those who stake UXD, the stablecoin, receive yield from the funding rate of the perpetual future position. When the funding rate is positive, yield will be distributed to the stakers and to the insurance fund. When the funding rate is negative (selling is more popular ∴ exchange price is lower compared to oracle price), the insurance fund will be used to pay out the negative funding rate to UXD stakers, so that they do not have to pay out interest.

Friktion - Volt #03:

Friktion is a crypto-asset portfolio management platform/protocol that offers structured products (called Volts) built on Solana.

For the purpose of this article, Volt #03: Crab Strategy is most relevant. Volt #03 puts on a short Power Perpetual position, which collects funding rates while delta hedging against directional price risks with a long Normal Perpetual position. Power Perpetuals are a form of perpetual whose index price tracks the price of an asset raised to a power (i.e. normal perps are to the power of 1 while power perps are to the power of n).

Power perpetuals can be beneficial and advantageous, as they can heighten returns.

For example:

You long 1 SOL. If SOL increases by 10%, your return in a normal perp is 10%:

(1 + .10) = 1.10

You long 1 SOL. If SOL increases by 10% your return in a power perp (let’s say to the power of 2) is:

(1 + .10)² = (1² + 2*.10 + 1) = 1.21)

Therefore, your return is instead 21%.

It’s helpful to run through the process of Volt #03 to see how it works.

A user deposits 1000 USDC into Volt #03. When the next epoch starts, the deposit becomes active. The Volt shorts BTC² (Power Perpetual), and collects yield through continuous funding payments. To remain delta neutral, the Volt also longs BTC (Normal Perpetual). The user profits as long as the price movement of BTC stays within the Profit Range (shown on the UI of Volt #03).

How does the Volt collect yield?

BTC² will always trade above the oracle price, since an upside move has a larger gain than an equivalent downside loss.

For example:

A 10% increase in BTC price:

(1 + .10)² = (1.1)*(1.1) = 1.21 = %21 gain

A 10% decrease in BTC price:

(1 - .10)² = (0.9)*(0.9) = 0.81 = %19 loss

Since BTC² is always trading above the oracle price, long BTC² holders (buyers) are always paying short BTC² holders (sellers), due to the funding rate, in the form of funding payments. Therefore, users of Volt #03 can generate yield as they take on a short BTC² position, and profit within the Profit Range.

The Profit Range depends on the funding rate of the power perpetual market. Higher funding rate means that there is a higher difference between BTC² and oracle price, which means that users will receive funding payments within a higher range. Therefore, the price of the underlying assets, BTC, can move within a higher range (be more volatile) and still be profitable for of Volt #03 users.

Juiced Protocol:

Juiced Protocol is an interest-rate arbitrage pool using delta neutral positions to earn yields, built on Solana. It executes cash and carry trades, which are trades which exploits price discrepancies/differences between the spot price of an asset and its derivative price.

So, when a user deposits stablecoins into a Carton (a vault), Juiced converts the stablecoin into SOL - making the user long SOL. Then, the protocol deposits the SOL into a derivatives DEX (i.e. Mango Markets) to use as collateral on the exchange. Using this collateral, Juiced enters into a Short SOL perp. The funding rate collected by the protocol is reinvested (auto-compounded) back into the position. Since the user’s Long spot position and Short perp position has the same notional value, the overall position of the user is delta neutral and does not change even if SOL price changes.

The protocol can also automatically manage capital and use it to gain exposure into other yield farms. As derivatives DEX’s allow leverage, Juiced can withdraw some of the collateral used to Short, and deposit it into stable yield farms to earn yield on them.

Rysk Finance:

Note: Not particularly similar to other products, but very cool.

Rysk is an upcoming protocol which will offer a dynamic (delta) hedging vault which will allow for liquidity providers to earn yield while staying delta neutral.

Rysk’s dynamic hedging vault (DHV) is a self-governing options AMM, which requires liquidity providers. The capital of those who provide liquidity to the vault, will be used to collateralize options sold through the DHV.

So, when a user buys a call or put option from the DHV, they change the delta exposure of the DHV. The DHV feeds its delta value into Rysk’s option pricing algorithm, which reprices options, to incentivize users to buy options that would move the DHV’s delta towards 0, thus allowing the vault to delta hedge.

For example, if a user buys a call option, and are now long one call option, they have a delta of 0.30. The DHV is short one call option, so its delta is -0.30. The DHV would reprice options that would incentivize users to buy put options that would move the DHV’s delta closer to 0 (delta neutral).

Through this mechanism the DHV earns while frequently incentivizing users to trade using it (and against it as a counter party) and hedging its delta exposure. By providing liquidity to DHV, liquidity providers can earn the premiums on the purchased options that the DHV sold, while also benefiting from having a source of yield that is not correlated to the price of the underlying assets (and thus is not affected by bear market conditions).

Lemma Finance:

Lemma is a protocol built on Arbitrum, that offers a basis trading vault and a decentralized stablecoin, called USDL, backed by arbitrage opportunities.

When users deposit assets into Lemma, Lemma will create a portfolio of “synthetic USD” on the users’ behalf and mint the equivalent amount of USDL. Lemma will use the deposited assets to buy ETH and deposit them to a decentralized derivatives exchange. This ETH will be used as collateral by the protocol to enter into a short perpetual position on ETH-USD. If users only want to mint a stablecoin, USDL corresponding to the value of the deposited assets is issued to the user. If the user wants to use the basis trading vault and earn yield, then the minted USDL is staked to access profits and losses from funding rate payments (the user receives xUSDL in return which reflects these profits and losses).

For example, if a user deposits $1000 worth of ETH, the user will receive 1000 USDL, and Lemma will create a portfolio of 1000 ““synthetic USD” on behalf of the user. Then, the protocol enters into a corresponding short Perpetual Future position on a derivative exchange, using the deposited ETH as collateral. If the price of ETH increases by $100, the users long position (the ETH that is used as collateral) increases by $100 as well. At the same time, the worth of the short position (the short Perpetual Future opened by Lemma once the user deposited) will decrease by $100. Therefore, the total change to the users position and the value of the users “synthetic USD” is 0, making it delta-neutral.

Lemma earns yield through funding rates - much like UXD does. Since funding rates in cryptocurrency are historically positive, when the protocol enters into a short position, it earns yield through positive funding payments.

Only users that stake their USDL are exposed to the profits and losses of the trading, while every USDL is always used to generate yield and returns through funding payments. Therefore, USDL stakers are exposed to the profits and losses of both their own USDL and the unstaked USDL.

NFA/I don’t know anything, I’m just looking at/learning about concepts/protocols I find interesting. Tell me if I got something wrong - @bigboyboccaccio.

Sources & Further Reading:

Sources:

Option Volatility and Pricing Strategies, Sheldon Natenberg

Options, Futures, and Other Derivatives, John C. Hull

https://docs.uxd.fi/uxdprotocol/

https://docs.friktion.fi/

https://juiced.fi/whitepaper.pdf

https://docs.rysk.finance/

https://medium.com/@rysk-finance

https://docs.lemma.finance/

Further Reading/Research:

Option Volatility and Pricing Strategies, Sheldon Natenberg

https://github.com/0xperp/defi-derivatives

https://www.paradigm.xyz/2021/08/power-perpetuals