# Harvest Volatility Yield with Friktion Volt#03

by: Friktion Research Collaborators

# Intro

Unlocking full-stack portfolio management is the focal point of Friktion’s Volts, our native structured products. In this article we’ll break down how Friktion Volt#03 manages a delta-hedged short power perpetual (perp) strategy to harvest volatility yield on stablecoin assets. We examine historical backtests observing strategy performance and discuss the risks of depositing into Volt#03.

Friktion recently launched Volt#03: Crab strategy. This Volt is designed to perform in sideways or ‘crab’ markets, harvesting volatility yield on stablecoins using power perpetuals.

Volt#03: app.friktion.fi/crab

Trade Power Perps: entropy.trade

# Table of Contents

**Review of perpetuals****What is a power perpetual?****Harvesting Yield from Power Perps****Volt#03: Crab strategy properties****User flow & execution****Historical strategy performance (backtest)****Daily volatility premium returns****Risks**

Learn more about perpetuals in Part I of the series. A perpetual instrument allows a user to speculate on the price of an asset without trading the underlying (spot) asset.

Perps uses a mechanism of “funding” to incentivize the trading price of the perpetual to track the price of the underlying asset a.k.a. the index price.

This funding rate is a scheduled payment that one side of a position (long or short) pays to the other. The funding rate incentivizes arbitrageurs to keep the perp trading inline with the index.

The size of the funding payment depends on how far away the perp is trading in relation to its index price. The direction of the funding payment depends on whether the perp is trading above or below the index price.

In a bull market, there is demand for leverage on the long side, causing the perp to trade at a premium and leading to a positive funding rate.

In a bear market, there is demand for leverage on the short side, causing the perp to trade at a discount and leading to a negative funding rate.

# What is a power perpetual?

A Power Perpetual is simply a perpetual raised to a power. To demonstrate this, consider the following:

A Power-1 Perp is a perpetual raised to power=1, equivalent to the payoff of a normal perp.

r = return

Value of a Perpetual (Power-1)= (1+r)¹ = 1+r

A 2x Levered perp has 2x the exposure of a normal perp:

Value of a 2x Levered Perpetual = 1+2r

A Power-2 Perp’s payoff is the returns of an asset raised to power=2:

Value of a Power-2 Perpetual = (1+r)² = 1 + 2r + r²

One way you can think about the fair value of a Power-2 Perp as a 2x Leveraged position *(1+2r)* plus a volatility position (*r²*)** that is always positive.**

If you’ve traded an option before, this volatility position (*r²) *might look familiar to you. Power-2 perps provide options-like exposure (“convexity” or “gamma”) without the need for strikes or expiries. Simply put, this means the upside gain is less bounded than the downside loss!

Since the Power-2 Perp’s volatility (*r²*) exposure is always positive, that means it will always trade more favorably than a 2x leveraged perp.

Power-2 Perps have an asymmetric upside. Long positions earn more on upside moves than they lose on equivalent downside moves.

**This creates natural demand to be long!**

Demand for long exposure causes the market price of the Power-2 Perp to always trade above the index price. If the Power-2 Perp could be bought at exactly the index price, **an arbitrageur could purchase volatility ( r²) for free.**

Since the market price is always trading above the index price, the funding rate will almost always be positive. **Short positions get continuously compensated by the longs via the funding rate in exchange for this asymmetric payoff**. This funding rate is equivalent to the implied volatility of an option.

The Power Perp funding rate represents the “volatility yield” that the short position generates for selling volatility risk.

# Harvesting Yield from Power Perps

Volatility yield is harvested using a short Power-2 Perp position. Friktion Volt#03 delta-hedges to improve your return profile. A naked Power-2 Perp position has a 2x levered short position (the *2r* term) baked in that is hedged by buying a 2x levered perp.

By hedging out the delta of the short Power-2 Perpetual position, a **delta-neutral** (market direction agnostic) volatility harvesting strategy is created.

This is what a hypothetical payoff would look with a delta-hedged BTC² Power-2 Perp (*Note:* this example assumes a starting BTC price of $40,000 when the position is opened)

# Volt#03: Crab strategy properties

- Directionally Hedged. Same outcome if market goes up or down.
- Volatility yield which scales with overall market volatility.
- Volatility yield that can be interpreted into a “profit range” over a certain time period, representing the range the market can move in the Epoch for the position to remain profitable (ex. +/- 6%)

**The profit range has the following properties:**

- If the asset ends within the profit range over the time period, the strategy profits.
- The longer the strategy is active, the wider the profit range becomes (see
*Friktion Volt#03 Payoff Diagram*) - The strategy makes the most money when the price of the asset doesn’t move from start to end.
**If the market moves less than implied by the volatility premium, then the strategy profits.**This is a similar short volatility mechanism that drives yield in Volt#01 and Volt#02.

The width of the profit range depends on how high the funding rate (volatility yield) is. **The range of profitability increases as the funding rate increases.**

Relationship between Power-2 perp funding rate and daily profit range: volatility yield APY increases as funding rate increases

The delta-hedged Power-2 Perp position harvests volatility premium and maximizes return when realized volatility of the market is low.

This payoff is ideal for users seeking yield in crab markets.

# Volt#03 User flow & execution

Volt#03 runs an automated volatility harvesting strategy utilizing stablecoin deposits with built in risk-management.🦀Use the strategy atapp.friktion.fi/crab

Let’s walk through a hypothetical example for how the strategy would work:

Alice believes that the crypto market will move sideways over the the next few weeks and wants to generate yield with this market view. Alice deposits $1,000 USDC into Volt#03 (Crab Strategy)!

- Per normal Friktion Epoch convention, the deposit is
*Pending*till the following Epoch begins.

At the start of the next Epoch, Alice’s $1,000 deposit goes from *pending* to *active* in the Volt. Alice receives a VoltToken which represents her share of the Volt. This token works similarly to VoltTokens in other Friktion Volts which you can read about here.

When Alice’s funds are active, the Volt puts on the delta-hedged Power-2 perp position on entropy.trade, Friktion’s volatility perpetuals exchange.

The Volt **shorts $500 of BTC²-PERP** and longs **$1,000 of BTC-PERP** on Alice’s behalf, creating the hedged position and maintaining a 200% collateralization ratio on the BTC² short. This over-collateralization drastically reduces any chance of getting Alice’s position liquidated. More docs here.

Alice’s position harvests continuous volatility yield in the form of funding payments for being short the BTC²-PERP. **Observe the increased return (profit range) with a longer hold durations:**

If the collateralization ratio falls to below a certain threshold due to adverse price movement, the strategy will rebalance its position back to its target 200% BTC² collateralization ratio. This minimizes downside risk and can be toggled in the future for various Voltages.

In summary, Volt#03 enters the delta-hedged Power Perpetual position for Alice and manages Alice’s risk, rebalancing its position based on market volatility and liquidity conditions to stay delta-neutral.

# Historical Strategy Performance (Backtest)

How has the crab strategy fared historically? This section dives deep into how Friktion researchers simulate historical strategy performance to measure yield sustainability.

Recall the *r²* volatility premium component from the funding rate in Power-2 Perpetuals is analogous to the “implied volatility” of an options contract. The fascinating thing about Power-2 Perpetuals is that the volatility premium value in the Power-2 Perpetual is the distillation across all options strikes and all expiries for an underlying asset! We can use this property to estimate what the Power-2 Perpetual funding would have looked like in the past by using the implied volatility from centralized options exchanges like Deribit.

Friktion is launching with BTC² rather than SOL² since BTC currently has the most liquid options market with the longest historical data that we can backtest with. *Note: *BTC is among the lowest vol cryptocurrencies, meaning the profit ranges and yields from ETH², SOL² will be wider and higher 👀

We use historical daily options data for BTC dating back almost 2 years from June 2020.

On each day, we fit a volatility curve across the strikes for each expiry for BTC. We interpolate between the implied volatility at +20 delta and -20 delta to estimate output a final implied volatility estimate for a given expiry on a given day. We use the 20 delta interpolation rather than the at-the-money volatility to take into account volatility smile and skew phenomena observed in options markets.

These imputed implied volatilities for each expiry on a given day allow us to create a replicating options portfolio. We linearly interpolate the implied volatilities between each expiry to create a replicating portfolio that mimics the payoff of a Power-2 Perpetual and gives us an estimate for the fair value of the volatility premium *r².*

More information on how this is derived can be found here. Notebook showing how the pricing is generated from a discrete set of options expiries and implied volatilities can be found here.

Friktion has chosen to use a 7-day funding period for our Power-2 Perpetuals. This means that the difference between mark and index of the Power-2 Perpetual market is paid out in funding over 7 days. This causes the replicating portfolio to have a majority of the weight concentrated in the 1-day, 1-week, and 2-week expiries, similar to the epoch lengths in Volt#01 and Volt#02.

# Daily volatility premium returns

Using this methodology, we can simulate a historical fair value of the Power-2 Perpetual and how the strategy would have performed across different market conditions:

As stated earlier, the volatility premium harvested depends on the market’s expectation of future volatility. This was especially high in January 2021 during the GME/AMC craze and in May when BTC experienced a massive bull market.

The volatility premium **( r²)**

*is the yield the short Power-2 Perpetual generates*

**.**The losses from price movement that the strategy experienced were the highest in Jan, May, and Oct 2021, periods where the market was in a historic bull market.

**The simulation results of a delta-hedged Power-2 Perpetual position show that historically this volatility harvesting strategy has been net profitable**. The daily rebalancing minimizes risk and prevents large drawdowns. Periods of sudden price movement in May and in November led to sizable drawdowns in the simulated strategy.

**Note: Past performance does not guarantee future performance.**

Below is the breakdown of Net Strategy PnL calculated as *Volatility Yield* (collecting power perp funding) minus the *Asymmetric Loss* from realized volatility (measured as the loss from prices moving out of the profit range).

# What are the risks?

All yield generation strategies come with risk. One of Friktion’s pillars is education and transparency around the risks associated with the search for yield.

## 1. Price Risk (if the price moves out of the profit range)

- If underlying asset ends outside of the profit range, Volt#03 will have a negative return.

## 2. Slippage Risk (if the exchange has enough liquidity)

- Entering and exiting positions using an exchange comes with trading fees, spread crossing, and price impact. This slippage will eat into the yield if the strategy overtrades or if the exchange does have enough liquidity to support the strategy deposits.
- Continuous liquidity is one of the biggest challenges for novel DeFi derivatives, particularly Power and Volatility perpetuals.

## 3. Liquidation Risk (If price moves extremely in one direction)

- Since the strategy is shorting a Power-2 Perpetual, it can get liquidated.
**Volt#03 minimizes the chance of liquidation by automatically maintaining a 200% collateral ratio on the Power-2 Perpetual for the user.**This risk management through the rebalance mechanism requires the underlying to move more than 161% in either direction before the Volt gets liquidated, a highly unlikely scenario.

## 4. Oracle Risk

- entropy.trade uses on-chain oracles from Pyth and Switchboard to track the index price. This oracle is used for account equity calculations, and can trigger liquidations if the oracle is mispriced. Entropy uses robust checks including confidence range, and freshness to ensure that erroneous liquidations will not happen. Entropy, built using Mango Markets, also wears Mangos smart contract risks.

# Overview

Friktion’s goal is to unlock volatility for portfolio management across all market cycles to generate sustainable and transparent yield for its users.

Friktion’s new Volt#03 Crab Strategy utilizes power perpetuals to generate sustainable yields with single sided stablecoin deposits that maximizes returns in rangebound markets.

# FAQs

**Q: Does Volt#03 hedge only at the start or does it continually delta hedge?**

A: The Volt hedges at the start and will delta hedge to reduce risk when market and liquidity conditions are triggered.

**Q: Why BTC² instead of SOL²?**A: Friktion believes it’s important to establish a viable proof of concept of crab strategy with an asset that has a liquid centralized options exchange so that liquidity providers can hedge. Liquidity is the biggest challenge for these types of DeFi derivatives. SOL² will come very soon :)

**Q: How is Volt#03 similar to LPing in an AMM?**A: Both have similar payouts in maximizing returns when the price of the asset doesn’t move. Volt#03 delta hedges for the user whereas LPers hold the delta exposure. The payoff functions are slightly different in that Volt#03 is a quadratic payoff whereas LPing is a square root payoff (impermanent loss).

# Links

Volt#03:** ****friktion.fi/crab**Trade Power & Volatility Perpetuals:

**entropy.trade**

**Twitter: @friktion_labs**

Discord:

**discord.gg/friktion**

Medium: friktionlabs.medium.com

Documentation: docs.friktion.fi

Lightning OG NFT: magiceden.io/marketplace/lightning_ogs