DeFi market so hot, how to hedge risk?
Original title: "DeFi Market so hot, How to Hedge Risk?"
Original author: Jarvis
Li Hanbo, Encryption Valley
The DeFi user is like a lobster in boiling water.
As prices fall, their capital is on the brink of liquidation, something most people do not realise.
If prices continue to buck the trend in the coming weeks, we could see a liquidation avalanche for DeFi. This will be the first lesson in DeFi risks for new DeFi users.
So far, DeFi users are not fully aware of the risks and leverage they are using on the capital they are locking in. They are no longer simply a motley crew. Instead, they need to manage their accounts as well as their exposure to margin. The situation is much like that of a regular passenger car driver being asked to get into a Formula One car. The only difference is that the DeFi user may not even know he is in the car.
That leaves a lot of capital at risk of liquidation if prices fall. Creates an environment reminiscent of March 2020 for price action. For someone who doesn't trade, it's suboptimal. For traders, this creates opportunities.
The reality is that most cryptocurrency users don't have the ability to spot this market trend. DeFi is unique in that it is not on an exchange. There is no order book, no long/short ratio. Tools have just been developed to better predict market corrections. Because these developments are so new, the first wave of traders who adopt these methods and techniques will be rewarded. That's the purpose of this article -- to show you the opportunity at hand.
Let's look at the state of the market through the perspective of DeFi, what it means for price action, and how traders can profit from this setup.
DeFi Market Status & NBSP;
In the last thirty days, nearly 2.5 million ETH and 50,000 BTC have been added to DeFi. You can see this in the DeFi Pulse chart below.
The first chart shows the number of locked ETH in DeFi growing from less than 4.5 million to nearly 7 million. At the time of this writing, a little over 6 million ETH are locked into the DeFi contract.
The second diagram shows the number of BTC locks in DeFi. This is a similar trend. In the last 30 days, nearly 50,000 BTC have been added.
This is a significant increase in a short time. And as that growth unfolded, prices reached their highest levels of the year.
In fact, over the past 30 days, the average price of Ethereum has been $402. The last time the ETH was this high was in July 2018. On the other hand, the average price of bitcoin is about $11,500. The last time it was at these levels was more than a year ago.
Speaking of DeFi, we must understand that most of the time when earning a yield, the asset is "locked" in a smart contract so that the user can borrow against it. This opportunity allows the borrower to generate a yield higher than the borrowing rate, or to trade with the borrowed money and earn a yield higher than the borrowing rate.
Collateral is what makes all this possible. So as long as the locked cryptocurrency remains worth more than the amount borrowed, all is well. The starting value of the locked collateral and the amount borrowed is often around 200%. That means the value of the locked asset is twice the amount borrowed.
In other words, the risk that the user takes on the encrypted asset that he or she locks. Because as the value of the asset they lock in goes down -- the price of the ETH goes down -- so does their mortgage rate. That's all that's discussed in the introduction, and that's where things start to get exciting.
To make this easier to understand, let's look at an example -- if a user deposits 10ETH for $402 at a 200% mortgage rate, he can borrow $2,010.
Now, when the PRICE of the ETH drops from $402 to $300, the proportion is no longer 200%, but 149%. When it reaches about 113%, or about $2,275, the 10 ETH in the DeFi contract can be cashed.
According to this calculation, this occurs when the ETH reaches $227. This means that if the price reaches $227 /ETH, an estimated 2.5 million ETH will be sold on the market.
It's important to keep that in mind.
First of all, we just went from $490 to $310 in a few days. Second, the liquidation did not start at $227. That's just the bottom line of the DeFi contract. In fact, near the peak of $490, assets locked up at a 200% mortgage rate have not yet been touched. They won't start until about $280.
Yet we are already seeing the reckoning begin.
By querying, you can see the history and real-time liquidation on the MakerDAO platform. You'll notice a few pages of clearing on September 5th, when prices hit their latest low.
This is just the tip of the iceberg, and if the price reaches below $280, traders can expect an avalanche of forced selling as the DeFi contract is cleared on the open market.
And 2.5 million ETH and 50 thousand BTC are not necessarily locked into the MakerDAO intelligent contract, but most are. In fact, YETH is one of the most popular and cherished financial vaults, and it's on the top 10 list of makerdaos with the largest pools of money. The problem is that most users aren't aware of the risk.
That is why this avalanche of selling is a real risk and sets the stage for aggressive price moments in the coming days and weeks.
How to do it & NBSP;
The encryption environment is changing, with new DeFi products coming out every day, attracting a wave of front-encryption speculators. In effect, these products are creating a market in which users are no longer just exposed to off-the-shelf leverage, but are using their assets.
It means the market itself is going through a shift and more cryptocurrencies are being leveraged. And what you may or may not know is that more leverage creates more volatility.
A simplified analogy is the car engine. As you add horsepower and start adding modifications, it gets from point A to Point B faster, but at the same time, faster speeds come with more risk. As speed increases, small bumps or wet surfaces can lead to fatal crashes. In a market where ETH and BTC generate more returns per dollar change, the risk of these fatal crashes becomes greater.
A day of price volatility is no longer just a bad day; it can mean a permanent loss of capital. That is why safety must be considered.
So how can traders get ahead in this changing environment? Or, how do you make trading safer in DeFi while overfulfilling returns?
1. Use more market indicators and tools
The indicators to which most traders are accustomed will no longer be so reliable. Trading volume and activity on the DeFi platform is increasing. Liquidity levels, leveraged positions and returns are not just controlled on the largest centralised exchanges.
It also means that the flow of cryptocurrencies in and out of exchanges no longer fully reflects buying or selling pressures on assets. Therefore, traders need to accept some tools, these tools can view DEX trading volume, the yield of various assets, various DeFi intelligent contract liquidation level, or even network mempool - the last tool is unique in that unidentified volume increase or network congestion may lead to more serious price correction.
Second, embrace derivatives
As volatility increases, so do new opportunities. This is a trader's dream. Because if prices go up and down more often, there are more opportunities to make money. Conversely, increased price volatility means increased opportunities for traders to lose positions in good plays. When this happens, it can be a frustrating experience.
This is why many traders leverage options. They allow traders to take advantage of this volatility while ensuring they do not get unwound on good entry times. It's an easy way to increase the odds of success.
Moreover, options are not unique to traders. DeFi users need to embrace DeFi opportunities as they explore them. It's a way of hedging against losses.
For example, if a new project promises a return of more than 200% to the ETH, users can "buy insurance" on their capital through a put contract. This allows DeFi users to make up for the potential losses they may suffer from a liquidation event. Of course, this could reduce the yield by a few percentage points, but it allows DeFi income farmers to explore riskier projects and safely allocate more capital to DeFi.
Here's an example:
If a DeFi user borrows 100ETH for $402 (at a rate of 200 percent) and anticipates a 13 percent capital loss, that user can buy a put contract. For each contract purchased at $402, they would gain a value of at least $102 if the price moved to a clearing mark near $300. This, in turn, gives them about 0.33 ETH for every contract they buy.
When volatility is low, a put contract close to "capital" (as measured by IV-- implied volatility) costs about 0.1 ETH and has a maturity of two months. That means a profit of 0.23 ETH per put contract.
For individuals, their 100 ETH capital may lose 13 ETH, and they can hedge this loss. If they bought five ETH put contracts for 0.1ETH per contract and the price fell from $402 to $300, their put contracts were essentially worth 0.23ETH per contract. Five ETH's worth of contracts is the equivalent of 50 contracts, or perhaps 11.5 ETH's worth of profits. This would almost offset the losses from DeFi liquidation.
This small scenario highlights the importance of risk management in DeFi and how to hedge when yields rotate.
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