Providing liquidity on a DEX? You’re getting shortchanged!
Tl;dr — if you are currently LPing on a DEX for major, well-established coins like BTC, ETH, BNB, etc, you’re getting shortchanged! Start selling options instead!
In our previous article, we established that without token incentives, the major Defi primitives of staking and lending/borrowing provide low returns without token incentives. In this article, we will explain why the other major Defi primitive — liquidity provision (LP) on a DEX — is a poor choice that leaves you open to big risks which you are not adequately compensated for.
A common term used to describe the risk of providing liquidity on a DEX is “impermanent loss” (IL). According to Amberdata.io, IL is when a token’s price change causes your share in a liquidity pool to be worth less than the present value of your deposit. In practical terms, as the price of an asset in an LP pool appreciates, you will own less and less of it, and as the price of an asset in a pool depreciates, you will own more and more of it. This means that you limit your upside gains while leaving yourself exposed to downside losses. In return for LPing, you get some of the trading fees. The loss is considered impermanent because you can recover the loss if the token pair returns to the initial exchange rate. This logic seems somewhat fallacious, like someone telling you that the BTC you sold at $1000 in 2017 is an impermanent loss that you can recover when the price comes back down!
In reality, LPing in a DEX is like selling both a call as well as a put option on the asset (also known as selling a strangle). Selling the call limits your upside, and selling the put opens up your downside, so you are taking a similar risk. However, the difference in returns are significant. Selling a 10-delta strangle on ETH yields in excess of 20% APR, compared with ~5% for LPing ETH on Uniswap. That is 4X more returns for the same risk! Most options vaults only sell either calls or puts, essentially halving the directional risk you take when compared to LPing, but that still means 2X more returns for half the risk!
To summarise the advantages of Options Vaults over DEXes for yield:
- You are exposed to less risk for more return.
- You are paid for your time holding an option position open. For LPing, you are not paid when no trades takes place.
- While all Defi products are subject to smart contract risks, there have been many instances of DEXes and LP pools being drained or rugged, but no options vaults have been compromised to date, due to the way the smart contracts and settlements are constructed.
In conclusion, LPing is an inferior way to deploy your assets for yield in the long term and deploying them into Options Vaults like Bonsai Strike provide much more reward for much less risk.
In the next article, we dive into the technical workings of options, the risks involved in depositing into Options Vaults, and how you can mitigate them.
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