🌕Automated Market Making
"He who has a why to hold, can endure any market volatility and earn massive stacks" - Friedrich Nietzsche
Overview
Automated Market Making is an on-chain strategy used to earn passive income on tokens. By depositing a pair of tokens into a smart contract, the smart contract uses them to make a market so others can trade back and forth against those deposits. In return, the deposit earns trading fees. These token depositors are called liquidity providers.
The more trading activity there is, the more fees are paid to the liquidity providers (LPers). These fees are distributed pro-rata to the LPers so that everyone earns the same percentage returns. These returns are quoted as an APR and referred to as yield.
There are also risks and a decrease in your tokens' prices will also decrease the value of your deposit. But when LPing, increases in prices won't increase the value of your position accordingly, and thus there is an opporunity cost associated with LPing. This is often referred to as Impermanent Loss. They call it Impermanent because if the price returns to your original deposit price, you would experience no losses.
How Do I Automated Market Make?
Simply by depositing into an AMM, users earn yield. The simplest AMM deposits are referred to as V2 deposits, or un-concentrated liquidity, or full-range liquidity. These deposits don't require any customization, you simply deposit an amount and start earning. However these types of deposits generally have the lowest yield. You can access this on Itos as the Basic LP.
Higher yields can be achieved by depositing concentrated liquidity, this means choosing a price range to deposit your assets into. Choosing a reasonable price range is key to earning higher yields. On the other hand, this deposit will experience more impermanent loss. A poor choice can easily cause more losses than profits. This type of deposit is high risk and high reward and therefore requires careful thought. This is also available on Itos as a Basic LP.
More advanced LP deposits let you customize your risk. They reduce the reward but in return can drastically reduce your potential losses. Choosing either IL Hedged LP or Real Hedged LP on the Itos AMM page will let you access these strategies without much overhead. There is an automatic hedge setting but feel free to customize it yourself for more control. Furthermore, these strategies also allow for leverage without liquidations if desired.
What are the Risks?
The primary risk of all Liquidity Provisioning is Principal Loss through Impermanent Loss. More is discussed in Principal Loss. The basic idea is that a basic LP does not appreciate in value as quickly as the underlying token, but losses in value approximately at the same rate as a depreciating token. Therefore it captures a token's losses but none of the token's gains. Instead its gains come from market making yield. This risk can be mitigated with hedges and smart price range selection. More is discussed in the next page.
When hedging, there is the additional risk that the fees paid for hedging begins to outweigh the fees earned from market making. This can happen if the price remains in the hedge range longer than it is in the market making range. This is clearly a mis-positioned LP and should be re-positioned at a different price range. This risk can be mitigated by LPing to wider ranges, choosing price ranges carefully, and monitoring the fee status of the LP deposit.
How to Choose a Strategy?
First we want to make sure you're comfortable with what Liquidity Provisioning does.
Once you've tried opening a range and earning fees, we would suggest trying the Impermanent Loss Hedged LP. This is not financial advice. Our backtests simply show stronger performance from IL Hedged LP's for volatile tokens than regular LPs.
For low-touch trading, usually the most successful positions are wider and help for around a year. Placing the hedges right outside the LP range has worked well in backtests, but of course past results are not indicative of future returns.
For ideas on how to strategize, check out our medium (medium.com/@itos.fi) or discuss on our discord (dsc.gg/itos).
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