Market-Neutral Strategy

Market-Neutral Strategy

What is the Market-Neutral (Pseudo-Delta-Neutral Strategy)?

Some veteran alpacas should already be familiar with the concept. We’ve written about this strategy in the past, which you can find in our Alpaca Academy here and our yield farming calculator here.
A Market-Neutral Strategy (Pseudo-Delta-Neutral) is a leveraged yield farming strategy where you can yield farm high APY pairs while minimizing your risk by hedging out market exposure. The Automated Vault eliminates market risk by farming long & short positions simultaneously, and rebalancing them for you to maintain neutral exposure. Or if we put it in alpaca language: high yield and low risk.
This is achieved by opening one long position and one short position at optimal sizing to achieve zero net market exposure on the volatile asset in a token pair. As the price of the volatile asset moves, the vault automatically rebalances the positions at ideal parameters so that they maintain 0 market exposure, while you earn yields from market-making the entire time.

How it works

1.) Farming with leverage allows you to earn higher yields. However, it comes with additional risk; Mainly, liquidation risk if the market moves against your position.
  • Example: If you open a 3x leveraged position on BNB-USDT (borrowing USDT), you will have a 1.5x long exposure on BNB.
2.) With the market-neutral strategy, we seek to eliminate the exposure on the volatile asset (i.e. BNB) by opening two positions: one long and one short in optimal sizing to hedge out the exposure on the volatile asset.
  • Example: For 3x leverage, the optimal ratio is 1/4 long position and 3/4 short position. As you can see below, the long exposure(all the way on the left) and the short exposure(all the way on the right) for BNB are the same size. That's the goal of this hedging strategy.
3.) As time passes, the positions will not remain neutral due to the accumulation of compounded earnings, borrowing interest, and price movements of the volatile asset. With the automated market-neutral strategy, we allow for the positions to fluctuate within a narrow range so as to not rebalance too often, but once the exposure goes beyond a pre-determined threshold, the Automated Vault will trigger a rebalance to reset the exposure back to zero. Setting the right threshold for rebalancing is key to operating this strategy. Rebalancing too often would incur higher swap fees as well as locking in the impermanent loss of the positions.
4.) One major advantage of using our Automated Vaults vs. manually performing similar strategies is that Automated Vaults running market-neutral strategies will not have liquidation risk. The Automated Vaults' positions will not have connected liquidation bots, or allow liquidation. However, there is effectively 0 additional risk of bad debt for lenders from turning off liquidation, because due to the two positions in this strategy hedging each other, the % change in equity value is small even after a large price movement. Furthermore, rebalancing to neutral once price moves is guaranteed through our automated rebalancing bots.
  • To illustrate the point above, let's take an example of the 3x leverage set up. In this case, the volatile asset's price could move 40% in either direction, and if we assume no rebalance were to happen, the equity value would only change < 7.5% (see figure below.) In reality, the rebalancing would have happened much earlier, which means the equity value change would be much smaller (mainly due to the lower swap costs and IL of rebalancing).