Lesson 1 - Alpaca Finance’s Unique Use-Case — Shorting at a Profit
Hello young Alpacas, and welcome, to Alpaca Academy. Here, we senior Alpacas will teach you about DeFi concepts, in particular, ones applying to Alpaca Finance. As such, today will be the first of a series of lessons to help you make the highest possible profits using our protocol, while customizing your positions in ways you can’t do anywhere else.
It may get a little long, but we promise it’ll be worth it, as we go over key principles that will not only help beginners, but also add value to advanced financiers alike.
You see, now that we’ve launched leverage yield farming, we can start sharing with you some of the things we’ve long been strategizing about in the barn, starting with advanced ways of utilizing our straightforward but powerful protocol.
In short, you can create strategies to customize your asset exposure through simple methods (i.e. shorting and hedging), and Alpaca Finance is the only platform in DeFi where you can do this in various ways — while earning yields!
Longing is the more common exposure method of beginner traders, where they hold an asset, profiting if price rises and losing equity if price falls. Opposite to that, is shorting.
Shorting is the act of selling assets in advance of acquiring them, with the aim of making a profit when the price falls. In essence, when you believe an asset’s price will drop, you borrow some and sell it, planning to rebuy that asset to repay the loan after price falls, when it has become cheaper. This is the same often-advised “buying low and selling high” that you would target with typical trading, except in reverse order, though just as profitable.
Shorting is a common practice amongst traders and speculators. Yet, in DeFi, and crypto in general, the options for shorting are limited and expensive.
You can take out a margin-short at a derivatives exchange, but for every second you hold that short and it doesn’t drop in price toward your exit target, you are losing money, paying the lender fees for borrowing the asset you’re shorting.
Well, with Alpaca, when you borrow from us, not only are you not losing money from borrowing interest, you’re gaining yields! Why? Because you’re using the held asset for farming! Where the yields almost always far outweigh the borrowing interest!
In fact, when you borrow an asset with us for leveraged farming at any leverage above 2x, you’re taking a short on the borrowed asset.
Here’s how it works. When you open a leveraged position, you are borrowing an asset from the protocol that you will have to pay back when you close the position (i.e. BNB/BUSD/ETH). Because our LP pools balance the paired assets(e.g., ETH-BNB or BNB-BUSD) at a 50:50 ratio, when your chosen leverage level is above 2x, you are borrowing more in one asset than you can put into the LP position. This is true regardless of which asset or combination of assets you add as principal.
That being the case, the protocol will need to convert part of that borrowed asset into the other paired asset to create LP tokens at a 50:50 ratio, regardless of what you deposit. Below is a simple example.
(Note: The prices in the following examples were for the asset prices at the time of writing the article and may not reflect current prices.)
- 1.You want to farm ETH-BNB so you add 1 BNB in principal
- 2.You choose 3x leverage so you borrow 2 BNB
- 3.You are now holding 3 BNB, but in order to create your LP positions, the protocol needs to convert 50% of that into ETH. Thus, the protocol sells 1.5 BNB (.5 * 3 BNB), converting it into ETH. You now have 1.5 BNB and ETH worth 1.5 BNB, and can create your LP position at a 50:50 ratio
- 4.Some time later, when you close your position, although you’re only holding 1.5 BNB, you still owe the protocol 2 BNB. As such, the protocol must buy .5 BNB using your ETH, giving you a total of 2 BNB that you pay back to the protocol
So to recap, you started by selling some borrowed BNB when you opened the position, and then you had to buy the same amount of BNB back when you closed the position. Selling then buying… Does that sound familiar?
Right! It’s shorting!
If the price of BNB dropped after you opened your position (when you sold BNB), that means you bought back the BNB at a cheaper price, aka sold high and bought low. In other words, you would’ve profited on this short!
And the size of your BNB short is exactly how much you bought in step 4, in this case: .5 BNB.
To cement this info, let’s go over the same example again but in more detail; the only difference being adding ETH instead of BNB as principal, showing how that makes no difference in the result when you leverage at higher than 2x.
- 1.You want to leveraged farm the ETH-BNB pool so you open a position, depositing .166 ETH which is worth ~1 BNB
- 2.You set your desired leverage to 3x
- 3.When you click Approve and open the position, the protocol lends you 2 BNB(“Assets Borrowed” at the bottom of the image above), which is 2x your principal value of ETH. In this way, your total position is 3x your deposited amount(1 unit(ETH principal) + 2 units (2x the ETH principal in BNB) = 3 units, aka 3x. This is the meaning of leverage level)
- 4.In order to convert your tokens into LP tokens to farm the ETH-BNB pool, they need to be added at a 50:50 ratio. Thus, since you have more BNB than ETH, the protocol will sell part of the borrowed BNB to achieve that. As in the prior condensed example, your position is worth a total of 3 BNB tokens, of which 1.5 need to remain in BNB and 1.5 need to be in ETH. At the moment, since you hold 2 BNB, the protocol will sell .5 BNB for you in order to achieve an even ratio (This is the selling part when you open the short).
At that point, the protocol will create your LP tokens, and add them to the pool. Congratulations, you are now leveraged farming, and you have a short position for the BNB that was sold into the partnered asset(ETH here), which in this example, is .5 BNB.
Now, let’s examine the details of your position, most of which you’ll be able to find on the Your Positions dashboard on the Portfolio page.
- As stated before, you have a total position value of ~3 BNB
- Debt Value is ~2 BNB, which is the value of the funds you borrowed
- Equity Value is 1 BNB, which is the value of the ETH you deposited
- Current APY is the net APY your leveraged farming position is earning after subtracting borrowing interest
- Debt Ratio is how much debt you have relative to your equity. In this example, since you borrowed 2x your equity, your debt ratio is 2/3 or ~66.7%
- Liquidation Factor (now renamed Liquidation Threshold) is the level which debt ratio would have to reach for liquidation of your position to be possible
- Safety Buffer is how much safe space you have before liquidation. It’s your Liquidation Threshold minus Debt Ratio
Now, let’s also examine your current asset exposure to ETH and BNB (in other words, how long or short you are to these assets).
- Your position is made up of half ETH and half BNB. Hence, we can take your Position Value at any time to understand the value of those halves. Here, since your Position Value is ~3 BNB, you are holding 1.5 BNB and ETH worth an equal amount of 1.5 BNB(~.249 ETH which is what we deposited)
- You are long on that .166 ETH portion of your position because unlike BNB, you will not have to pay any ETH back. Thus, the price movement of ETH affects your equity value directly. In fact, this kind of long exposure is what you have when you farm anywhere else without leverage, and as with all long exposure, when the value of ETH rises, your ETH increases in value and you profit. When the value of ETH drops, you lose money. When you close your position, you will receive the value of the ETH at closing time. If the price of ETH when you close is higher than the price of ETH when you opened the position, you profited longing this ETH.
- In the other half of your LP position, you are holding 1.5 BNB. However, you are not long 1.5 BNB, because you have a debt of 2 BNB. Remember, when you opened your position, you borrowed 2 BNB, and when you close the position, you’ll have to pay that back. Yet, you are only holding 1.5 BNB, so what does that mean for your BNB exposure? Well, as we covered before, it means you’re shorting BNB!
- That 1.5 BNB is not a long exposure because you’ll be paying it back in BNB, regardless of whether the price of BNB goes up or down. Your exposure to that 1.5 BNB is neutral. However, that .5 BNB you owe is a different story. When you borrowed it and the protocol converted it into ETH so you could enter your LP position at equal ratios, you effectively sold .5 BNB, which you will have to buy back to return it when you close the position. Hence, while your position is open, you are short .5 BNB. The price movement of BNB thus affects you in the opposite manner to how ETH price affects your ETH long. If the price of BNB when you close is higher than the price of BNB when you opened the position, you will lose money shorting this BNB. That’s because on a short, you are betting the price will go down! To reiterate, when you close a short to repay it, you’d prefer the price was cheaper. Then you could spend less on repaying the loan than when you first took it, pocketing the difference as profit.
In sum, here is your total exposure on your ETH-BNB position:
Long .249 ETH(worth 1.5 BNB)
Short .5 BNB
Now, let’s compare the above to the total exposure on an ETH-BNB position if you had simply deposited an equal Position Value yourself of 3 BNB, without taking leverage (So you deposited .249 ETH and 1.5 BNB at 1x):
Long .249 ETH(worth 1.5 BNB)
Long 1.5 BNB
Notice the differences between the exposures in the examples above. The position values are the same, but instead of being long on the BNB, you’re short on it because you took out a loan for a leveraged position.
So, if you didn’t know before, now, you know how to short! Give yourself a pat on the back, young Alpaca! Because shorting opens up many new possibilities for you to profit!
As I’m sure you’ve seen, prices move up and down. Yet, if you’re only able to long, then you can only gain equity when they move up. With shorting, you can now place bets and profit when prices move down!
What are your exact profits and losses given any future price of ETH or BNB? To find out, read Strategy 5: Yield Farm Proftiably in a Bear Market, which serves as a more advanced supplement to this article. That article also discusses your risk of liquidation when conducting this strategy.
So as you can see, unlike with other platforms, with Alpaca, you’re not forced to only go long on the farmed assets. After all, if you’re bearish on BNB in the examples above, wouldn’t you prefer to be short BNB rather than long?
Think back. Haven’t you had experiences farming or providing liquidity where your yields were good but the farmed underlying assets of your position dropped in value, making you take a loss at the end? With Alpaca, you no longer have to suffer that!
This is the power of shorting, to have choices! And it gives you power in all market conditions! For instance, think about what would happen if the market ever turned bear (okay, markets swing between bear and bull cycles so this is inevitable, but we Alpacas are optimistic!). In a bear market, it’ll be difficult to make money liquidity mining on other platforms since the farmed assets keep dropping in value. However, at Alpaca, that won’t be the case! With us, you’ll be able to keep farming while going short instead! Betting with the bear market instead of getting crushed by it! In other words, you’ll be able to farm not only in Spring and Summer, but in all seasons!
Wouldn’t that have been nice to have in 2018–2020? We sure think so. 😆
You may have a few doubts:
So I can short, that’s great, but isn’t it only really possible for BNB and ETH now? After all, those are the only non-pegged assets I can borrow.
That may be true now, but we plan to keep adding more lending pools for additional primitives: BTCB, ALPACA, and others. You’ll be able to short all of these! In the future, once governance is implemented, users will be able to vote to add more assets as well.
On another note, one other interesting thing you may not have realized, is that borrowing BUSD, is shorting to profit from fiat inflation!
Why are many people bullish about crypto? In truth, there are lots of reasons, but even among institutions, isn’t one major reason — that they’re actually bearish on fiat?
Now, if they were to align their capital with their beliefs, wouldn’t they be looking to profit from shorting fiat? Well, they can do that easily with Alpaca!
Ok, I get it, I can short on Alpaca’s platform. So what though? I’ve been around. Shorting is nothing new. I can short at derivatives exchanges with margin, or by taking out loans on some assets at lending platforms. Why wouldn’t I just use those?
Wow, you really understand the market. But, ask yourself, when you short using those platforms — doesn’t it cost you money?
In other words, shorting with the other options on the market — always starts at a loss!
If you open a margined short at a derivatives market, you’ll be paying borrowing fees every minute your short is open. There is no getting around that. Shorting like that costs money, and it isn’t cheap. You’re only betting that the price drops enough to cover that cost. However, on our protocol, you can make that same bet, and profit! Because while your short is open, instead of bleeding out money to borrowing interest, you’re collecting yields as rewards! That is to say, shorting with Alpaca — you always start at profit!
Think about that for a moment, because Alpaca Finance is the only place where you can short multiple assets while earning yields in a simple way.
That’s true not only for BNB Chain and Fantom…
Not only for DeFi…
Not only for crypto…
But even — in all of traditional finance!
(Note: the closest type of trade setup to shorting while earning yields is where you would long the underlying spot asset such as BTC, then take a short position on BTC with a derivative like a futures contract to create a neutral hedge. From there, you’d attempt to collect the funding rate on the short if most other traders were going long. However, this setup requires specific market conditions, is not stable as the funding rate can flip at any time, has very small APYs relative to farming, and is not simple to set up at all)
This is all possible at Alpaca because our shorts plug into leveraged farming, earning fees through acting as AMMs, which covers not only the borrowing interest associated with shorting, but adds significant yields on top!
Yet, that isn’t the only unique strategic value of Alpaca Finance. We can discover an additional advantage by examining another type of competitor within DeFi — lending protocols.
There are some DeFi lending protocols where you can deposit collateral and borrow assets. If you sell these assets when you receive them, you can effectively go short. However, these also often come with borrowing interest, and even if that interest is 0%, there is still a massive cost with using other lending protocols to short — opportunity cost. That’s because all of the mature lending protocols on the market — only allow overcollateralized loans!
What does that mean? Well, if you deposit 1 BNB-worth of crypto into these protocols, they will never give you 1 BNB-worth of another asset. It will often be .5 BNB-worth. So even if their borrowing interest is 0% and you short with this 50% worth of your collateral, then farm with the other 50%, that other 50% of your untapped collateral is sitting around and not bringing you profit!
At most, some protocols may offer very low APYs, below or around 10%, a far cry from what you can make farming. Well, in finance, money you fail to gain is the same as money lost. This is the opportunity cost associated with overcollateralized loans. Instead of taking out that overcollateralized short and waiting for the price to drop, you could’ve farmed with double that principal instead, making double the yields. This is a big loss. Then, what about with Alpaca?
Our platform not only does not force you to borrow overcollateralized, but offers you undercollateralized loans! Rather than giving you only 50% of your collateral like other options, some of our pairs provide up to 6x leverage, which means you can farm with 600% of the value of your collateral!
The effect is that your short will be larger, and your principal for farming will be 12x as large as a lending protocol that only gives you 50%! You’ll be making 12x the yields!
In summary, within all of finance, Alpaca Finance is the only platform that makes it easy to profit in one of the two possible trading directions (shorting).
In addition, we’re one of the few places in all of crypto that offers undercollateralized loans, let alone at such a massive leverage level.
What does all this mean for the future of Alpaca Finance? we’ll let you make the conclusion. 😎
We senior Alpacas hope this lesson has been helpful. Yet, we know some of you may not be interested in shorting, or may find it too complicated. Well, in the next lesson, we’ll show you how you can still farm with high leverage while neutralizing your short, as well as teach you about the general concept of neutralizing asset exposure — called Hedging.
We’ll teach you how powerful hedging can be, allowing you to open farming positions where you avoid long or short exposure entirely, so you can sit back and farm without having to worry about asset prices rising or falling. And guess what? Just like shorting at a profit — Alpaca is also the only place where you can farm while hedging!
Yep, we’re super proud of this farm of ours. So for you young Alpacas who’ve just joined the herd, we know it may be a little intimidating at the beginning, but stick with us, and you’ll be stronger than a llama in no time.
(Note, due to the assets being used to farm on AMMs inside LP tokens, asset rebalancing occurs, which means that shorting and hedging in this manner are not the same as in other protocols; To be specific, the asset exposures are dynamic, changing slightly with price movements as the AMMs adjust the assets’ balances relative to each other. This is something we will also cover in the next article.)