Lesson 2 - Introduction to Hedging with Double-Sided Borrowing
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Today, we’re going to explain to you how Alpaca Finance platform gives you the ability to create powerful strategies for hedging risk. Of course, we’re talking about double-sided leveraged yield farming.
We’re thrilled to be the first leveraged yield farming protocol on BNB Chain to offer this feature. With this feature, you can select which asset to borrow when opening leveraged yield farming positions on the pairs where we have deposit vaults for both assets. Some examples of the supported pools are:
BNB-BUSD (3x)
BNB-ETH (3x)
ALPACA-BUSD (2.5x for borrowing BUSD, 2x for borrowing ALPACA)
BTCB-BNB (3x)
BTCB-BUSD (3x)
USDT-BUSD (3x)
ETH-BUSD (3x)
To understand how this feature benefits you, you must first understand your exposure to each asset at different leverage levels.
1x leverage is the same as the standard farming you can do anywhere else. Above 1x, you’ll be borrowing an asset, which will allow you to multiply your farming position, providing you higher yields.
The asset other than the one you borrow will have leveraged long exposure so your equity value will increase when its price rises. This is the same as standard yield farming.
For the borrowed asset, at 2x leverage, you’ll have neutral exposure to that asset. This means at position opening, your equity value will be indifferent to a modest rise OR fall in the borrowed asset’s price; hence — neutral.
(*For users who want to hedge neutral: Keep in mind that large double-digit price moves will shift your exposure on the borrowed asset from neutral to slightly long or slightly short. So opening one position at 2x is not the best way to hedge neutral. The 2x is only neutral at position open and is used as an example only to illustrate that. Later in this article, we’ll show a better strategy to hedge neutral using multiple positions, which can stand larger price moves. You can also view examples of these shifts from a user’s experience here, or get an idea of how your exposure changes affect position value using our yield farming calculator.)
Above 2x, you will have a slight short on the borrowed asset, meaning your equity value will increase when that asset’s price falls, and your equity value will decrease when the price rises.
Below 2x, you will be long on both assets, but more long on the one you didn’t borrow.
Previously, when opening LYF positions, you were limited to borrowing only one type of asset. For example, if you wanted to leveraged farm ETH-BNB, you were forced to borrow BNB. As mentioned above and in our previous article, when your leverage > 2x, you are shorting the asset you borrowed. What this means in our example is that you are shorting BNB when leveraged farming ETH-BNB. This is a bit of an inconvenience if you have a view that BNB price will outperform ETH. Now, with our double-sided farming, that’s no longer the case.
If you believe, BNB will outperform ETH, then you can choose to borrow ETH instead and be long BNB while shorting ETH! To maximize your profits, if you have a choice of which asset to borrow, consider borrowing the asset OPPOSITE TO the one you are most bullish about. For example, in ETH-BNB, if you expect BNB’s price to rise more than ETH’s price, then borrow ETH.
In addition to being able to customize your positions by selecting which asset to borrow, this feature will allow for more sophisticated farming and hedging strategies.
For example, you’ll be able to farm at maximum leverage on a higher APY pair while also hedging neutral. One such pair you can do this on is BNB-BUSD, by opening two positions that borrow each asset, thus nullifying their exposures to become neutral. Below, we’ll give an example of such a setup. However, before continuing, make sure you understand how longing & shorting work by reading our previous article on the subject.
(1) First, you will open a BNB-BUSD position, borrowing BUSD at 3x leverage. For this example, you’ll add 1000 USD-worth of tokens as collateral.
Added collateral: $1000
Total position value: $3000 (borrowed 2000 BUSD)
Exposures:
BUSD: short 500 (effectively neutral because BUSD is pegged to USD and thus very unlikely to rise or fall. If you don’t understand why the short is 500 instead of 1500, then read this)
BNB: long 1500
(2) Next, you’ll open another BNB-BUSD position, but this time, you will borrow BNB at 3x leverage, and you’ll add 3000 USD-worth of tokens as collateral.
Added collateral: $3000
Total position value: $9000 (borrowed 6000 BUSD)
Exposures:
BUSD: long 4500(effectively neutral)
BNB: short 1500
(3) Now, let’s sum up the total exposures when combining the two positions above:
Added collateral: $4000
Total position value: $12000 (borrowed 8000 BUSD)
Total Exposures:
BUSD: long 4500 - short 500 = long 4000(effectively neutral)
BNB: long 1500 - short 1500 = 0 (neutral)
As you can see, with this type of strategy setup, you’ll have similar neutral exposure to what you would have on a stablecoin-stablecoin pair at position open. Yet, you’d be farming a higher APY pair, earning larger yields!
This is a strategy you can only achieve due to double-sided borrowing, and it’s something you can’t get on any normal yield farm, which forces you to suffer long exposure on both assets. At Alpaca though, we like to empower our herd with the most powerful farming tools; golden tractors and all that…
So now, enjoy farming in any way you like, fellow Alpacas. In the next lesson, we'll go into more details on the best hedging strategies using leveraged yield farming.
(*One important caveat for users intending to hedge neutral: due to the nature of LP tokens, the AMM rebalances your assets when price moves. What people in DefI often refer to as Impermanent Loss comes from this mechanic. What this means is that as prices move, your neutral exposures shift. Typically as price rises, the asset exposure becomes a bit more short, and as price drops, the asset exposure becomes a bit more long.
You can reset this exposure to neutral by adding collateral(if price rose and became more short) or by closing the position and reopening it, but you take slight losses each time you do so, so that isn’t a good strategy to do this often to reset to neutral exposure. Rather, borrowing ALPACA in BUSD-ALPACA at 2x is only effective if you’re betting the price of ALPACA will range, aka won’t change much. Even then though, you would be better off opening 2 counter-balancing positions at 3x in the format given in this article to be neutral, because you would receive more farming yields at higher leverage.
So to summarize, the neutrality you get by borrowing an asset at 2x is not the same neutrality you get by creating a neutral hedge combining two positions with higher leverage than 2x. The example given in this article of combining 2 positions is more effective to create a neutral hedge.
We’re working on products to short/hedge without asset rebalancing. Meanwhile, you can use our calculator which has charts that show how movements in price affect your equity values due to the underlying exposure shifts.)
For an in-depth example of a multi-position hedging strategy using Alpaca, you can read https://medium.com/leverage-farming-with-alpaca/pseudo-delta-neutral-with-alpaca-4df49289e167
You can also check out our Automated Vault, which will manage double-sided leveraged yield farming position for you and automatically adjust the positions as asset prices move, in order to reset the net exposure back to the desired target. You can learn more here.
