What are the nuances of trading yield farming on Uniswap V3?
AMM (automated market making) of Uniswap is based on the formula of options. You put two coins, ETH and USDT, for example, in the pool. And pool size is connected to ETH, it will be changed due to price action, and the quantity of ETH will be changed from 0 to the Maximum value equaled to deposited ETH plus deposited USDT/(StartPrice*LowBoundPrice)⁰,5. PoolSize is equivalent to Delta Greek in options.
You must choose the range. Compared with the options, the Range is equivalent to Duration, because short range means the short-term goals of your pool position, and wide range means the long-term goals of your pool position.
So, depositing your crypto in the pool on UniV3 you do the same as you would sell the options. While the price of ETH will stay in the range, you will continue earning yield, once the price of ETH goes outside you will temporarily stop earning and get an impairment loss.
Impairment loss matters and it means the loss which occurs when the price goes outside the range.
An example of impairment loss,
ETH costs 1600 usdt. You have the funds valued at 32000 usdt. You bought 10 ETH for 16000 and have the rest of 16000 usdt in your account. You added in the pool ETH/USDT 50/50 with a range of 1450 to 1750. Your initial pool position is 10 ETH and 16000 USDT. Change from this initial pool size will create an impairment loss. if the price goes up to 1800, your initial pool size will cost 10*1800+16000 = 34000, but your ETH was sold in the pool with a price (1600*1750)⁰,5 = 1673,5, so you will have pool position 32735 USDT. The difference between 34000 and 32735 will be your impairment loss.
How much you can earn?
You can play with the Uniswap calculator here https://unispark.metacrypt.org/ to see how much fees you can earn.
You can choose how much commission in the pool you will earn. There are pools with 0,01%, 0,05%, 0,3%, and 1% commissions. When the traders make a swap ETH to USDT, they take liquidity from the pool with the lowest commission, but if there is not enough liquidity for the same price, AAM will come to the next pool and take liquidity there, if the swap is too big for millions of USDT, they can take a liquidity from all 4 types of pools. The most liquidity pool usually is 0,05% so, the most liquidity from the swaps comes there.
Depending on the range you trade APR or annual profit rate can be from 5% to 150%. When you trade a narrow range to earn more commission because, in the narrow range, a big part of your liquidity will always be used in providing liquidity and receiving the commissions, you will face often price going outside your range and you will fix impairment loss that can be bigger than you earned the commissions.
I’d recommend you to know more about strategies for selling options because the mechanism is the same. For example, if you expect the market will drop down you can make a pool with a range from the current price to the level where you expect there will be support for a price. If you expect the price will increase you can make a pool with a range from the current price to the level which can be an extremum. You can make different pools by repeating the patterns of options.
You can also make a diversification opening the different pools with wide and narrow ranges so they will have reduced total risk compared with only narrow-ranged pools.
Now the fees in the ETH chain are low, and you can add/reduce liquidity in the pools without thinking about the fees. But it can be sometimes very high up to 300–500 usdt per transaction in the equivalent. In this case, the changes in the pool that make you sign the transactions on the ETH chain will be a problem, and you can be limited in the activity due to high fees.
Hedge pool with an option?
To hedge the pool with an option you should find the needed options to choose it.
For example, you make a pool with a range of 1400–1800 with a current price of 1600. For example, if the price goes up, it works for you and you take the impairment loss. You want to hedge only a move down.
When a price reaches a low bound of 1400, your position will be 50 ETH, your current position is around 22 ETH. So, you will buy 28 ETH.
So, you need to choose a Put option that has a delta of 0.22 now and will have a delta of 0.50 when the price will be 1400. But this put can cost more expensive than your expected weekly earnings. So, you should compare the cost of the option and your expected earnings and decide whether to do it or not. Maybe, you can make it partially. The hedge should not be always 100% of possible risk, if you partially reduce risk, you will have a more attractive risk-to-profit ratio named the Profit factor, so it’s better than without a hedge and with a full hedge.
Please make comments, on what you like or not in Uniswap trading, and what you want me to cover in more detail. if you have already had your own experience, let’s make a change in our successes and wrongdoings.
Whitepaper Uniswap V3 where you can find all formulas of AMM and impairment loss. https://uniswap.org/whitepaper-v3.pdf
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