Introducing Hedging Vaults by Stake DAO Derivatives.
One year ago, Stake DAO launched its first derivatives strategy. It brought to the market the innovation of selling fully collateralized options while using this collateral to farm in some of DeFi’s most profitable yield farming strategies, thereby skewing the risk profile of the strategy in favor of the user. Now widely replicated by the market, these strategies have proven their efficiency, even though they can suffer in a highly volatile market.
However, due to the success of these strategies, a lot of protocols followed Ribbon and Stake DAO’s path to build new DOVs (Defi Option Vaults), either on different assets, different timeframes, different chains, or simply pure forks. The TVL across those DOVs has surged, as shown in this article.
Due to this phenomenon, hundreds of millions of options are sold in the market every Friday, representing a huge chunk of the total daily volume, regardless of the price of those options. This massive selling pressure brought down the price of options, and therefore, the implied volatility became incredibly underestimated compared to the true volatility experienced by the market. This initial back testing, which led to the choice of 0.1 delta as the main strategy, became outdated. Stake DAO reacted to this by developing their own volatility model to make sure the risk profile of the strategy stayed stable. But this couldn’t change the fact that a structural imbalance is present in the market and that options currently trade at a very low level.
To conclude, markets are recently experiencing unprecedented uncertainty , while options have never been so cheap (ETH options are trading at a volatility around 80%, while one year ago, they were trading around 150%). Therefore, we have been thinking about ways to take advantage of this cheap volatility while providing value to our users, and this is where our latest hedging vaults come into the picture.
Understanding hedging vaults
Hedging vaults are strategies in which users protect their position automatically from rapid market movements. To protect users’ position, the strategy buys options every week. Every Friday, a portion of the collateral of the strategy is sold and used to buy this protection. The strategy buys those options from the other option strategies which generate yield from the sale of options. While the long vaults (Covered Call and Put Selling strategies) are generating a high yield by taking some risk on, the hedging vaults generate negative weekly yield but reduce the risk profile of the user and give the opportunity to take advantage of big market movements.
The ETH Black Swan Hedging Vault
The first hedging vault launched by Stake DAO is the ETH Black Swan Hedging Vault. As its name suggests, this vault allows users to take a long ETH position while being protected against sudden large downward movements of the ETH price.
Users can deposit ETH or WETH in the vault, and every week, a portion of the TVL is sold for USDC to buy put options from the ETH Put Selling Strategy. If the market doesn’t move significantly and the option ends up out-of-the-money, the vault’s position will have decreased by the premium value. If the market drops and the option ends up in-the-money, the ETH Put Selling strategy will pay the hedging vault the difference between the expiry price (price of the oracle on Friday 8 a.m. UTC).
The payout of the strategy depending on the expiry price, as shown here:
Since we have nearly one year of experience of the ETH Put Selling Strategy, we can easily backtest the performance of the ETH Black Swan Hedging Vault. If the Black Swan vault had been launched at the same time as the Put Selling strategy, the hedging vault would currently have a cumulative performance of +16.5%.
As we explained earlier, the main reason for this high positive performance is that the selling pressure on options coming from DOVs leads to undervalued options, and skews the risk profile in favor of the buyer.
If we dive into the figures of the current market, the price of the options the strategy would buy each week would be around 0.5%, protecting user funds against negative price movements that exceed 15%. This means that the strategy pays a c.25% APR to be protected against ~15% price movements (in current market conditions).
This strategy can be interesting to fulfill many different objectives. It can notably be seen as an insurance against black swan events or as a way to take a bet on future volatility.
Why should I use the hedging vaults instead of buying my own protection?
There are many reasons why it can be more advantageous to use Stake DAO’s hedging vaults rather than buying options directly.
- Better pricing: by exchanging options between the long vault and the hedging vault, Stake DAO cuts out the middleman and ensures that a bid-ask spread no greater than 10% will be suffered by the user. This is much more attractive than what can be found on the market, where the bid ask spread is generally much higher. For example, for the options that the vault would have bought this week, the bid-ask spread is currently 20%.
- By using the vault, the user would have benefited from cheaper options (0.0055 instead of 0.0060).
- Onchain, with trustless Web3 connection: many current platforms in DeFi have very low liquidity, and a very small amount of different options available. To find suitable options themselves, users would need to go to a CeFi platform such as Deribit, which would imply taking the counterparty risk and being required to fulfill KYC.
- Automated management: with hedging vaults, once the user has selected their strategy, they can simply let it run. The risk is computed using Stake DAO’s proprietary risk assessment model to ensure a stable risk profile, and all the operations linked to the management of the vault (auction, acquisition, settlement) and the gas costs associated, are performed by the DAO.
- Present on L1: due to the high gas cost of using options on a regular basis, most option platforms are present on various L2 (Polygon, Arbitrum, Optimism, etc.). For users that don’t want to take a bridge risk or are willing to trade large amounts of options, the best, (and the only) possibility is to buy options on Ethereum via Stake DAO’s hedging vaults.
Deposits and withdrawals
Users can deposit funds at any time during the week. The deposited funds will be added to the strategy each Friday just before the acquisition of new put options.
When put options have been acquired but have not yet expired, the funds are locked in the strategy to avoid unfair gaming of the strategy by malicious users.
For this reason, it is not possible to withdraw from the strategy while the position is open. Options will expire every Friday at 08:00 UTC, and the position will be closed after a 2.5-hour dispute period.
At any time, users can ask to withdraw their funds and will be able to claim them when the position is closed on the following Friday. These funds will not be returned to the strategy and will remain in the vault until claimed by the users.
This mechanism enables the strategy to maximize the protection of funds while ensuring every user is treated equally.
The ETH Black Swan Hedging Vault won’t be our last! We are currently studying many other possible option vaults. If you have ideas about what strategies should be next, please don’t hesitate to come to Stake DAO’s Telegram chat or Discord server to share your thoughts, where they will be warmly welcomed!