LP Position Risks & Rewards

Understanding the risks of holding a LP position on Gamma Options: Option risk, trading risk, price divergence, and LP position liquidation explained.

Vol-range AMM enables liquidity providers (LPs) to achieve high leverage through the use of concentrated liquidity combined with margin usage. LPs can borrow capital and lock it within a predefined volatility range, optimizing their capital efficiency.

While LPs earn from trading fees, achieved by selling high and buying low, it's crucial to understand and manage the associated risks and rewards.

LP Position Rewards

All trading fees that LP position earns are collected in $USD and are stored inside of LP position.

Accrued fees are not part of the available cash that is used for LP Health calculation, because it's important to isolate LP position liquidation risk from the performance of the LP position. For example, large LP position can accrue over $10k, but the liquidation risk is only $300.

Fees are however part of the overall value of the LP position used for account margin, meaning that fees accrued are used for Account Health calculation.

Since LP positions are highly leveraged, risks and rewards are both multiplied with Margin and AMM leverage. Let's consider the following example:

LP position example:

- Options in range: 100 options,

- Range: 40% - 50%,

- Current volatility: 45%, in range,

- Cash reserves: $7500,

- Option price: $50,

- Underlyng price: $1600,

To open above position, LP provided $7500 from his margin account, and also borrowed 50 ETH on which he is paying 10% APR.

Assuming he is the only LP on this market, and that daily volume is only 25% of all the TVL (25 options traded), he is earning around 25 x $1.6 = $40/day on fees, but also paying $21.9/day on borrow rate.

Taking everything into account, he is earning $18.1/day on a $7500 investment, which translates to somewhere around 88% APR.

LP Position Risks

Here are the four primary risks that LPs need to monitor and manage:

  1. Option risk

  2. Trading risk

  3. Price divergence

  4. LP liquidation risk

Before delving into each of these risks, let's establish a sample LP position that we can examine from various perspectives.

LP Position Setup

  • ETH Price: $1600

  • Strike Price: $1600 (ATM)

  • Option Price: $100

  • Volatility: 40%

A user opened an LP position in the ATM call market, selecting a volatility range of [30%, 50%] with a 40% volatility level at the time of opening. This market has no other LP positions. The position breakdown is as follows:

  • LP is buying 10 call options within the 30% - 40% volatility subrange.

  • LP is selling 10 call options within the 40% - 50% volatility subrange.

The user deposited $2000 on the buy side and 10 call options on the sell side into the AMM.

Option Risk

Option risk is the inherent risk associated with holding long or short option positions, similar to what a trader would face. Various Greeks quantify these risks:

  • Delta: Exposure to changes in ETH price.

  • Gamma: Exposure to changes in Delta.

  • Theta: Exposure to option time decay.

  • Vega: Exposure to changes in volatility.

  • Rho: Exposure to risk-free rate changes.

LPs have the ability to hedge their LP positions, similar to how they would hedge a long or short position. For example, if a trader sells one call option, using our previous LP position as an example, with volatility now at 39%, the LP's position would become long one option. Consequently, the LP position would exhibit positive delta, gamma, vega, and rho, and negative theta. The ultimate profit or loss at expiration depends on the final ETH price.

Let's look at this example: A retail trader sells one call option into our LP's volatility range. In our earlier LP position scenario, volatility drops to 39%, and the LP now owns one option. The LP position has positive delta, gamma, vega, and rho, but negative theta.

If this remains the only trade in the option market until it expires, the LP position could end up with either a profit or a loss, depending on ETH's final price at expiration.

Trading Risk

Trading risk pertains to the dynamic profit or loss that an LP position may experience due to changing market conditions. Unlike option risk, which is relatively static, trading risk is fluid. Let's illustrate this with an example.

Example 1: if the LP bought an option for $100, and the ETH price subsequently drops, reducing the option's value to $90 (without changes in volatility or time), then the LP position would incur a $10 loss if trader would buy back that same option (while the trader would realize a $10 profit).

The same can occur due to time decay. It's important to note that trading losses can also be trading profits.

Example 2: if the LP sold an option for $100, and enough time passes, reducing the option's value to $90 (without changes in volatility or ETH price), then the LP position would realize a $10 profit if trader would sell back that same option (while the trader would incur a $10 loss).

Over an extended period, trading risk typically tends to balance out, approaching zero.

Price Divergence

Price divergence, commonly known as impermanent loss in the crypto space, relates to volatility-driven price fluctuations. To grasp the concept, consider our LP position from the previous example, which provided liquidity within the [30%, 50%] volatility range. For the sake of simplicity, we'll temporarily disregard other factors affecting option prices, such as ETH price and time.

If volatility rises to 50%, the LP sells all their call options at an average price of approximately 45%. This mirrors the concept of impermanent loss seen in price-range AMMs, with the distinction that we are now considering volatility ranges. Nevertheless, the loss for an LP in this scenario is tangible and can be quantified in USD terms. Conversely, if volatility drops to 30%, the LP buys back all their call options at an average price of around 35%, incurring a loss due to buying prematurely. Importantly, if volatility returns to its initial level (40%), the loss becomes impermanent and returns to zero.

LP Liquidation Risk

LP liquidation can occur when LP Health drops below 125%. In short, LP is charged with a $300 penalty, and balances from LP positions are returned to his Margin account, netted out with any previous positions he might have.

LP liquidation is already covered in how LP Health is calculated, and LP Liquidation posts.

Understanding and effectively managing these risks is essential for LPs to navigate the dynamic world of DeFi options trading on the Gamma Options platform.

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