In another one of our educational docs, we talked about diversification, a popular way that investors offset their risk. Hedging may seem similar, in that different positions are taken to minimize losses if an asset crashes. Hedging is more complicated, but you definitely shouldn’t be turned off, as the practice can bring profits even if an asset falls, which diversification cannot.
The Difference Between Diversification and Hedging
Diversification is the practice of spreading your investment across different assets. In the world of crypto, this can mean moving your funds across tokens from different sectors. Correlation plays a part here; for example, investing in a number of DEX tokens whose movements are correlated is not great diversification. Then there is diversification across blockchains, platforms, and even stablecoins to consider. As we have recently seen, a large drop in the market can cause certain stablecoins to lose their peg against the asset they are linked to.Hedging can also involve looking at correlation, but is less about diversification and more about taking opposite approaches to investing in the same or closely related asset. There are many different ways you can hedge, but one of the most straightforward ways is to take a long position in an asset, while simultaneously taking a short position; that is, betting that it will go lower in price. As crypto is volatile, you may profit in the long run through your long position while collecting profits from a short-term fall from your short position. If this doesn’t occur, you are still offsetting some risk, as you will see some gains regardless of whether the coin has a sustained upward run or falls.
How can you hedge with leveraged yield farming?
Leveraged yield farming involves putting up collateral and borrowing tokens. With PembRock Finance, you can borrow up to 3x your current holdings to take advantage of the high APY that farms are offering. This does, however, leave you with debt that is paid off as a percentage of rewards that are accrued.
This is where it gets interesting! Leveraging by 2x or more puts you in a position where you can effectively short the coin in your token pair that you have borrowed, providing an effective hedge in the event of a market downturn. This works due to the fact that you can profit from the position of the coin you used as collateral while paying back a smaller amount of debt, due to the borrowed coin’s fall in value.
PEM-USN is the farm that (at the time of writing) offers the greatest rewards on PembRock Finance, with an APY of 542%, or 175% APR.
Farmers that want the opportunity to maximize their returns can borrow PEM; with leverage above 2x, users can get returns from the APY and hedge the value of the PEM token.
If the PEM token rises, the farmer will profit from the increased value of the overall position and the compounding interest gained from farming.
If the PEM token falls, the farmer will profit from the compounding interest gained from farming, while their debt value shrinks relative to their overall position.
Here’s how it can be done:
Go to PembRock Finance and open a PEM-USN position, borrowing PEM with leverage.
Let’s say PEM is $0.12 and you choose to farm 60,000 tokens, roughly corresponding to 7,200 USN. In sum, your position will come to US$14,400 — the 50/50 ratio of 60,000 PEM and 7,200 USN required within the liquidity pool contract.
You can put up $4800, leveraging 3x to borrow 80,000 PEM tokens ($9600) (which you will short), giving you your total of $14,400 which is split evenly between PEM and USN.
Remember, you have to return the coin you’ve borrowed, so you are banking on the fact that USN will outperform PEM.
As your initial deposit and borrowed tokens are converted to a 50/50 farming position, your holdings will look like this:
Short 60,000 PEM ($7,200) - farmed
Long 6,000 USN ($7,200) - farmed
With a PEM exposure of 1.5x, you will be earning 3x the amount of farming rewards you otherwise would be while having to pay back less due to the fall in the value of PEM.
Please note: This kind of position works best as a short-term strategy to hedge against any long-term positions.