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Feb 15, 2023, 13 tweets

1/13 Why are some pools good ๐Ÿถ and other pools bad ๐Ÿ˜ˆ?

The answer comes from breaking down LP profits into:
1. Price changes ๐Ÿ“ˆ
2. Fees collected ๐ŸŽŸ๏ธ

By comparing LPs to options, we discover parallel insights โ€” let's explore! ๐Ÿงต

2/13 Price changes
โฌ†๏ธ Price up: positive return
โฌ‡๏ธ Price down: negative return
โคต๏ธ Payoff determined by delta (ฮ”) & gamma (ฮ“) of LP position

Why use options terminology (ฮ” & ฮ“) for LPs?
Hint: that payoff looks awfully like a short put option!

3/13 Fees collected
โ€ข Determined by theta (ฮ˜) of LP position

๐Ÿ•’ ฮ˜: Rate of time decay (dV/dฯ„)
๐Ÿ’ฐ dV = fees collected
๐ŸงŠ dฯ„ = 1 block

โ†’ ฮ˜ = fees per block ๐Ÿคฏ

โœ… Near the money: ฮ˜ > 0
โŒ Far the money: ฮ˜ = 0

4/13 In TradFi, options selling is more profitable when Implied Volatility (IV) > Realized Volatility (RV)

Can we compare IV-RV for LPs?

Yes! But let's use fees instead of IVs since:
โ€ข Easier calculation ๐Ÿงฎ
โ€ข Fees collected โ‡” options premia ๐Ÿ‘‡
โ€ข โฌ†๏ธ options premia โ‡” โฌ†๏ธ IV

5/13 Results match TradFi!

๐Ÿถ Good pools (green dots): lie below the line, compensated by high fees given volatility ("IV > RV")
๐Ÿ˜ˆ Bad pools (pink dots): lie above the line, not compensated enough ("IV < RV")

(Dot values are summed returns from LPing)

6/13 How do price changes and fees affect returns?

โฌ†๏ธ Price โ†’ โฌ†๏ธ LP returns (since fees are always positive)
โฌ‡๏ธ Price โ†’ โฌ†๏ธ LP returns if ฮ˜ dominates
โฌ‡๏ธ Price โ†’ โฌ‡๏ธ LP returns if ฮ” & ฮ“ dominate

Let's define "dominance" so we can analyze pool returns! ๐Ÿ‘‡

7/13 We define a metric to measure how much fees dominated LP returns

ฮ˜ dominance = fees / [ fees + |payoff| ]
(fees & payoff expressed as percentages)

Meaning:
๐Ÿ’ช100% ฮ˜ dominance โ†’ fees drove 100% of LP returns
๐Ÿค•0% ฮ˜ dominance โ†’ price movement drove 100% of LP returns

8/13 Previously, we found that LPing on $ENS was highly profitable (+124%), but $UNI was not (-28%)

By graphing ฮ˜ dominance next to cumulative returns, we find:
๐Ÿ˜” Bad days (negative returns) driven by price movement
๐Ÿฅณ Good days (positive returns) driven by fees

9/13 Breakdown of positive & negative returns confirms that
good pool ฮ˜ dominance > bad pool ฮ˜ dominance:

๐Ÿ˜”Bad days: 28% ($ENS) > 22% ($UNI)
๐Ÿ˜ŠGood days: 59% ($ENS) > 50% ($UNI)

The good pool also had a higher proportion of good days:
๐ŸคฉENS: 63% (272/433)
โ˜น๏ธUNI: 55% (335/608)

10/13 The good pool's fees made up for its bad payoffs ($ENS):
Fees: 466%
Payoff: -371%
Return: 95%

The bad pool's fees weren't enough to compensate ($UNI):
Fees: 309%
Payoff: -332%
Return: -23%

(All values are summed)

11/13
๐Ÿ“ฃ Key Insights:

1. LP = short option payoff
2. ฮ”, ฮ“, and ฮ˜ affect LP returns
3. LPs compensated when IV > RV
4. Good days/pools driven more by fees than by price changes

12/13 Disclaimer:

๐Ÿ“ข None of this should be taken as financial advice.
โš ๏ธ Past performance is no guarantee of future results!

13/13 Comment below with questions.

Follow @Panoptic_xyz and @BrandonLy1000 for more #ResearchBites and other key updates!

Check out our blog ๐Ÿ‘‰ panoptic.xyz/blog
Star & follow our GitHub repo ๐Ÿ‘‰ github.com/panoptic-labs/โ€ฆ

๐Ÿค Like & Retweet if you found this thread helpful!

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