Uniswap V3 Delta Neutral Strategy-Part 1

10 min readNov 3, 2023

Hey Neutrons,

Welcome to Part 1 of our Uniswap V3 Delta Neutral Strategy series!

In this article, we’ll dive deep into Uniswap V3, unpack the idea of concentrated liquidity, break down its key equations, and highlight the risks of impermanent loss in concentrated liquidity pools. Plus, we’ll show you how our strategies tackle these challenges to minimize IL and maximize yield.

TL;DR

Uniswap V3 introduced Concentrated Liquidity, optimizing capital efficiency but increasing the risk of Impermanent Loss.
An example with Bob showcases that liquidity provision in Uniswap V3 poses a 27 times higher risk of impermanent loss than V2 during equivalent price fluctuations.
Neutra Finance’s Delta Neutral Strategy for Uniswap V3 aims to earn trading fees while minimizing risks through hedging against ETH volatility, auto-compounding rewards, and data-driven rebalancing.

Uniswap V3: A New Era in Decentralized Finance

With the introduction of the Uniswap V3 license this summer, the decentralized finance (DeFi) landscape saw a surge in concentrated liquidity decentralized exchanges (DEXs). Uniswap V3, boasting enhanced features, quickly surpassed the trading volume of its predecessor, V2.

When users choose a DEX aggregator, their transactions now predominantly pass through V3. This evolution has not gone unnoticed by arbitrageurs, who are leveraging Uniswap V3’s capabilities, especially since arbitrage activities are a primary source of fee revenue.

Concentrated Liquidity: A Game-Changer

Uniswap Labs introduced Uniswap V3 with a feature called Concentrated Liquidity. This feature allows Liquidity Providers (LPs) to set a specific price range, termed the ‘Spread Range’. Essentially, Providers determine the minimum and maximum prices at which they’re willing to trade their assets in the pool.

While it optimizes capital efficiency, it also increases the chance of exposing LPs to impermanent loss, especially if they choose a narrow spread range. If the asset’s price moves outside this range, LPs will stop earning trading fees. To continue earning, LPs must ensure their Spread range position remains within the current trading price, often necessitating manual rebalancing and continuous market monitoring.

Impermanent Loss in Uniswap V3

Impermanent Loss occurs when the prices of assets in a liquidity pool diverge, potentially leading to losses for LPs compared to simply holding the assets. In the context of Uniswap V3’s liquidity pools, the narrower the range you choose, the higher the potential for fee earning. However, this also means a higher risk of Impermanent Loss. Think of it as a trade-off: higher potential earnings come with increased risks.

If the price ventures outside the chosen range, LPs are left holding only one type of asset and won’t earn any trading fees until the price re-enters their specified range. LPs must find a balance between optimizing fee earnings and managing the risks associated with price movements outside their chosen Spread Range.

A Practical Look at Liquidity Provision: Meet Bob

To further understand the risk on Liqudity provision on Uniswap V3, let’s consider Bob, a liquidity provider. With the introduction of Concentrated Liquidity, Bob now has the ability to define a specific price range for his assets, tailoring his liquidity provision strategy to align with his market expectations.

Providing liquidity isn’t as straightforward as having a 1:1 ratio with token pairs. The amount will be determined by the lower tick price and/or upper tick price, let’s do calculations as follow:

Let’s set the scenario:

Current ETH Price: $2000
Bob’s assets: 1 ETH and a yet-to-be-determined amount of USDC
Bob’s chosen Spread Range: 7.5% at the current price ($2000)
— Upper limit (tick): $2150
— Lower limit (tick): $1850

Determining Initial Liquidity:

How much USDC should Bob provide for his 1 ETH? Let’s break it down:

1. ETH Initial Liquidity (Lx):

Where:
X = Amount of Ethereum (1 ETH in this case)
Px = Current price of ETH ($2000)
Pb = Upper tick price ($2150)

2. USDC Initial Amount(Y):

Where:
Pa = Lower tick price ($1850)

Using the equations above, we can determine how much USDC Bob needs to provide as LP as follows:

By applying the above formulas, Bob determines he needs roughly 2153 USDC to offer liquidity alongside his 1 ETH.

But, What Happens if ETH Price Drops to $1900?

Calculating Bob’s Future LP Composition

To determine the composition of Bob’s pool after the price drop, we need to know Future Composition of Bob’s LP using Equations below:

1. Future Amount of ETH (Fx)

Where:
FPx = Future price of ETH ($1900)

2. Future Amount of USDC (Fy)

Using the equations above, we can calculate Bob’s LP composition as follows:

and

From these calculations, if ETH’s price drops to $1900, Bob’s liquidity pool would comprise approximately 1.7315 ETH and 727.04 USDC.

Calculating Bob’s Impermanent Loss (IL):

In summary, IL represents the potential loss from providing liquidity instead of just holding assets.

To compute Bob’s Impermanent Loss, we need to know the value of Bob’s assets if he didn’t provide liquidity and the value of Bob’s assets in the Liquidity Pool using the equations below:

1. Asset Value if Held (tvH)

2. Asset Value in Liquidity Pool (tvL)

Using the equations above, we can calculate the value of Bob’s assets if he just held them as follows:

and

Thus, from the calculation above, we know that Bob’s assets would be valued at $4052.98 if held, and $4016.87 if provided as liquidity.

Lastly, to determine Bob’s Impermanent Loss (IL), we simply need to calculate:

From this calculations, Bob’s impermanent loss would be approximately $-36.11 or -0.89%.

However, What if Bob providing LP in traditional AMM (Uniswap V2) instead?

Uniswap V2 utilizes an automated market maker (AMM) system, ensuring the product of the quantities of the two tokens in a pool remains constant.

This is represented by the AMM formula:

Where:
Y = Amount of USDC
X = amount of ETH
L² = Constant Amount

Let’s set the scenario:

Current ETH Price: $2000
Bob’s assets: 1 ETH and 2000 USDC
Future ETH Price: $1900

From the AMM formula above, we can determined the value of L as:

L²=2000 * 1
L²=2000
L=44,72135955

And, based on the AMM formula, then we know y and x value as follow:

then,

To determine the initial liquidity value (tv0), we can use the following formula:

1. Initial Liquidity value (tv0)

Now, if the ETH price drops to $1900, Let’s calculate the future Liquidity value(tvL):

2. Future liquidity value(tvL):

Where:
FPx = Future ETH Price ($1900)

3. If Bob hadn’t provided LP on Uniswap V2, the asset value held(tvH):

Now we know if ETH price drop to $1900, by providing liquidity, Bob’s assets decrease to $3,898.72 (tvL), whereas holding them would value them at $3,900 (tvH).

Now, let’s calculate the impermanent loss Bob incurs by providing liquidity on Uniswap V2.

4. IL calculate based on the following formula:

IL = tvL — tvH
IL = 3898,7177379236–3900
IL = -1,2822620764 or -0.0328759494%

Where:
tvL = Future Asset value Liqudity
tvH = Asset value if bob didn’t provide LP

Let’s determine how much larger the impermanent loss (IL) on Uniswap V3 is compared to Uniswap V2, we can use the formula:

Conclusion

On Uniswap V2: When Bob provides 1 ETH initially priced at $2000, and the price drops to $1900, he experiences an impermanent loss of approximately -0.0329%.
On Uniswap V3: Under the same conditions, Bob’s impermanent loss is around -0.89%.
the impermanent loss on Uniswap V3 is approximately 27 times larger than on Uniswap V2.

This highlights a significant difference in impermanent loss between Uniswap V2 with traditional AMM and Uniswap V3 with Concentrated Liquidity for the same price movement.

Trading with leverage, as seen in Uniswap V3, can be a double-edged sword. While concentrating a position allows liquidity providers to earn a larger portion of trading fees, it also heightens the risk of impermanent loss.

How to Fix the Problem?

Historically, the challenge of impermanent loss was tackled by diversifying assets or opting for broader price ranges when providing liquidity.

Liquidity Managers, who actively adjust positions in response to market movements, were also a solution. However, these strategies often come with trade-offs, either in the form of reduced fee earnings or the necessity for constant intervention. Uniswap V3’s concentrated liquidity model, being more intricate than V2, makes the role of a Liquidity Manager both vital and demanding.

To navigate this challenge, Neutra Finance developed a Delta Neutral Strategy, specifically designed to earn Uniswap V3 trading fees while minimizing risks.

Uniswap V3 Delta Neutral Strategy by Neutra Finance

Uniswap V3 Delta Neutral Strategy by Neutra Finance will stand out in the DeFi landscape. It’s not just another liquidity strategy. This Strategy is meticulously developed to hedge on Aave and auto-rebalance assets within a specific debt ratio. It offers a robust solution to the age-old problem of impermanent loss.

The Pros of Delta Neutral Strategy

Optimized Returns: Our strategy aims to maximize fee-based earnings, giving liquidity providers the best possible returns.
Mitigation of Impermanent Loss: Through intelligent rebalancing, our vault minimizes the risks associated with impermanent loss, a common issue in liquidity provision.
Automated Management: Say goodbye to manual adjustments. Our vault takes care of asset positioning based on real-time market data.

A Closer Look at Our Delta Neutral Strategy

Hedging Against ETH Volatility: To safeguard against the unpredictable price movements of ETH, we implement a two-fold approach:
— Borrowing from AAVE: We borrow ETH from AAVE and subsequently deposit it into the Uniswap V3 ETH-USDC pool. This strategy is designed to create a market-neutral exposure to the ETH price, ensuring that our position remains unaffected by its price volatility.
— Rebalancing for IL Prevention: Regular rebalancing of our position is crucial to prevent the accumulation of impermanent loss. By constantly monitoring and adjusting, we ensure that our assets remain within the optimal price ranges.
Data-Driven IL Minimization: Our strategy reduces impermanent loss by utilizing back-tested data on past rewards and fees, followed by asset rebalancing within optimal price ranges based on the debt ratio.
Auto-Compound: Our strategy automatically compounds LP rewards. Auto-compounding occurs with every strategy rebalance, making it more cost-effective.
Dedication to Excellence: We are continuously monitoring & refining our strategy to provide the most effective solution for liquidity providers.

By leveraging this approach, liquidity providers not only enjoy optimized returns but also find a reliable shield against the market’s unpredictable swings. With the Uniswap V3 Delta Neutral Vault by Neutra Finance, we’re not just offering a solution; we’re revolutionizing liquidity provision.

Sit back & relax, Neutrons ☕️

Upcoming Article: Dive deeper into the strategy and results from backtesting.

Neutra Finance

Neutra Finance aims to make risk-hedged, sustainable investment strategies easily accessible for anyone, anywhere, through automated strategy vaults. We strive to make this process simple and easy so that anyone who wants to protect their funds and earn stable returns can do so in any market condition.

Upon depositing your capital into our vaults, you can sit back and earn APY above-market standards on high-performing DeFi products while the strategy will do the rest.

If you have any inquiries, feedback, or partnership proposals feel free to contact the team via Discord or Marketing@neutra.finance !

Official Links: 🏠 Website | 💬 Discord | 🐦 Twitter | 🌐 Telegram | 📄 Documentation