Lesson 8: Risk Management and Hedging Strategies
Lesson 8: Risk Management and Hedging Strategies
π― Core Concept: Protect Capital First
Professional LPs don't just earn feesβthey manage risk. This lesson teaches advanced risk management techniques including delta hedging, LVR mitigation, and portfolio-level risk controls.
π‘οΈ The Risk Management Framework
Three Types of Risk
1. Impermanent Loss (IL):
Opportunity cost vs. holding
Reversible if price returns
Mitigated by: Stable pairs, hedging
2. Loss Versus Rebalancing (LVR):
Value extracted by arbitrageurs
Never reversible (monotonic)
Mitigated by: Lower volatility pairs, faster chains
3. Smart Contract Risk:
Bugs, exploits, hacks
Permanent loss
Mitigated by: Audited protocols, diversification
π Delta Hedging Strategy
The Concept
Delta = Sensitivity of position to price changes
Delta Hedging = Neutralize price exposure, profit only from fees
How It Works
Step 1: Provide liquidity (long both assets)
Example: 1 ETH + 2,000 USDC in pool
Delta: Long ETH exposure
Step 2: Short ETH to hedge
Borrow ETH on Aave
Sell ETH for USDC
Delta: Short ETH exposure
Step 3: Net position
Long ETH (from LP) + Short ETH (from borrow) = Delta neutral
Profit: Fees - Borrowing costs
Complete Example
Setup:
LP Position: $10,000 (5 ETH + 10,000 USDC at $2,000/ETH)
Borrow: 5 ETH on Aave (50% LTV)
Sell: 5 ETH for 10,000 USDC
Net: Delta neutral
Monthly:
LP Fees: $100
Borrowing cost: $50 (5% APY on ETH)
Net: $50/month (0.5% monthly = 6% APY)
If ETH drops 20%:
LP IL: -$1,000
Short profit: +$1,000
Net: $0 (hedged!)
If ETH rises 20%:
LP IL: -$1,000
Short loss: -$1,000
Net: $0 (hedged!)
Result: Isolated fee yield, no price exposure!
When to Hedge
Hedge if:
β Large positions ($50k+)
β Volatile pairs
β Want pure fee yield
β Can afford borrowing costs
Don't hedge if:
β Small positions (costs too high)
β Stable pairs (IL minimal)
β Want price exposure
β Can't afford borrowing
π Portfolio Risk Management
Position Sizing
Rule 1: Never risk more than 5-10% per position Rule 2: Diversify across pairs, protocols, chains Rule 3: Correlated pairs count as one position
Correlation Matrix
High Correlation (count as 1 position):
ETH/BTC
wstETH/ETH
USDC/USDT
Low Correlation (separate positions):
ETH/meme coin
Stablecoin/volatile asset
Risk Limits
Maximum Exposure:
Single pair: 10% of portfolio
Single protocol: 25% of portfolio
Single chain: 50% of portfolio
Example ($100k portfolio):
Uniswap V3 ETH/USDC: $10k (10%)
Aerodrome WETH/USDC: $10k (10%)
Raydium SOL/USDC: $10k (10%)
Reserve: $70k (70%)
π― LVR Mitigation Strategies
Strategy 1: Lower Volatility Pairs
LVR Formula: LVR β ΟΒ² (volatility squared)
Implication: Halving volatility = 4x less LVR
Action: Choose stable or correlated pairs
Strategy 2: Faster Chains
LVR is block-time sensitive:
Ethereum (12s blocks): Higher LVR
Arbitrum (0.25s blocks): Lower LVR
Solana (0.4s blocks): Lower LVR
Action: Use L2s or alternative chains
Strategy 3: Dynamic Fees
Meteora adjusts fees with volatility:
Higher volatility = Higher fees
Compensates for increased LVR
Action: Consider Meteora for volatile pairs
π¬ Advanced Deep-Dive: Options-Based Hedging
Protective Puts
Strategy: Buy put options to protect downside
Example:
LP Position: $10,000 ETH/USDC
Buy: $10,000 put option (strike $1,800)
Cost: $200 (2%)
If ETH drops to $1,600:
LP Loss: -$1,000
Put Profit: +$1,000
Net: -$200 (just option cost)
If ETH stays above $1,800:
LP: Normal returns
Put: Expires worthless
Net: -$200 (option cost)
Covered Calls
Strategy: Sell call options to generate income
Example:
LP Position: $10,000 ETH/USDC
Sell: $10,000 call option (strike $2,200)
Premium: $150 (1.5%)
If ETH stays below $2,200:
LP: Normal returns
Call: Expires worthless
Net: +$150 (premium earned)
If ETH rises above $2,200:
LP: Normal returns (capped)
Call: Exercised (sell ETH at $2,200)
Net: Premium + capped gains
π Risk Monitoring Dashboard
Key Metrics to Track
Daily:
Current IL vs. fees earned
Position value changes
Price vs. range boundaries
Weekly:
Net PnL (fees - IL - gas)
Comparison to holding
Risk limit compliance
Monthly:
Total return analysis
Portfolio rebalancing
Strategy adjustments
Risk Alerts
Set Alerts For:
IL exceeds fees (losing money)
Price exits range (V3)
Position exceeds risk limits
Gas costs exceed fees
π Beginner's Corner: Risk Management Basics
Q: Do I need to hedge? A: Only for large positions ($50k+) or very volatile pairs. Start without hedging, learn first.
Q: How much should I risk? A: Start with 1-5% of portfolio per position. Increase as you learn.
Q: What if IL exceeds fees? A: Withdraw and reassess. Don't wait hoping it improves.
Q: Should I diversify? A: Yes! Across pairs, protocols, and chains. Don't put all eggs in one basket.
Q: How do I monitor risk? A: Use analytics tools (APY.vision, Revert Finance) or track manually weekly.
π― Key Takeaways
Risk management protects capital - fees alone aren't enough
Delta hedging isolates fee yield from price exposure
Portfolio limits prevent catastrophic losses
LVR mitigation requires low volatility or fast chains
Options hedging is advanced but powerful
Monitor risk metrics weekly to catch problems early
Start conservative - increase risk as you learn
π Next Steps
Module 3 covers elite operations: Uniswap V4, MEV tactics, governance, and building complete LP systems. These advanced topics require solid risk management foundations.
Complete Exercise 8 to develop your risk management framework and calculate hedging strategies.
Remember: Professional LPs manage risk first, optimize returns second. Protect your capital, and the fees will follow. Unmanaged risk destroys more LP positions than low fees.
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