Understanding Delta Hedging

Derivatives are a zero-sum game: if you win, someone else loses. This was true until today – enter Smilee Atomic Delta Hedge.

In the realm of DeFi, there's a pervasive misconception: if traders are making a profit, it means that liquidity providers (LPs) are incurring losses. This zero-sum perspective overlooks the sophisticated risk management strategy that Smilee employs – Atomic Delta Hedging, which allows for a more nuanced interaction between traders and LPs, where both parties can potentially benefit.

What is Delta Hedging?

Delta, one of the most crucial risk measures in finance, quantifies how an asset's price movement impacts your profit and loss (PnL). For instance, a delta of 0.5 indicates that a 1% increase in the asset's price would result in a 0.5% gain.

In traditional finance (TradFi), market makers who sell options typically hedge their delta with each trade to mitigate risk. This involves adjusting their positions to maintain a balanced exposure as the delta changes over time. However, in the DeFi space, effective delta hedging has been a challenge.

Smilee's Atomic Delta Hedge

Smilee introduces a revolutionary approach with its Atomic Delta Hedge, which automatically hedges the Vault delta with every trade. This ensures that the overall risk remains aligned with the risk profile of a Uniswap V3 LP. The benefits of this approach include:

  • Reduced Impermanent Loss: Smilee’s strategy ensures that impermanent loss borne by Earn Vaults is minimized compared to Uniswap, before accounting for slippage.

  • Consistent Delta Exposure: The Earn Vaults' liquidity is rebalanced with every trade, ensuring the delta exposure remains equivalent to that of a decentralized exchange (DEX) LP.

  • Traders' Profits are Fully Covered: Traders' profits are perfectly covered by the Atomic Delta Hedging, thus traders' PnL, even if extremely positive, does not impact the Earn Vault PnL.

Demystifying the Counterparty Misconception

Thanks to Atomic Delta Hedging, the belief that traders' gains come at the direct expense of LPs does not apply to Smilee. In Smilee, the counterparty to traders' profits is the impermanent loss that LPs faces. As a result, LP payoff is defined as:

Where Smilee APY includes:

  • Impermanent Gain Premiums

  • AMM Bid Ask Spread

  • Atomic Delta Hedging Impermanent Loss Mitigation

In the formula there is no impact from Traders PnL, which is totally covered by Atomic Delta Hedging. Actually in many scenarios both LPs and traders can emerge as winners.

Here a cool example:

Benefits of Smilee's Approach

By leveraging advanced delta hedging techniques, Smilee ensures that the interests of both parties are aligned, transforming the landscape of DeFi trading and liquidity provision.

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