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Good Pools and Bad Pools on Uniswap V3

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Good Pools and Bad Pools on Uniswap V3

Discover why some LPs outperform by breaking down returns into price action, fees earned, and IV-RV.

Brandon
Mar 20, 2023
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Good Pools and Bad Pools on Uniswap V3

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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


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!

Fees collected

Fees collected are determined by the theta (ฮ˜) of the 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


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:

  • Easier calculation ๐Ÿงฎ

  • Fees collected โ‡” options premia ๐Ÿ‘‡

  • โฌ†๏ธ options premia โ‡” โฌ†๏ธ IV

Results match TradFi! ๐Ÿ‘‡

  • 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)


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‘‡

We define a metric to measure how much fees dominated LP returns:

\(ฮ˜\text{ }dominance = \frac{fees}{fees + |payoff|}\)

(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

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

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)

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)

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


Disclaimer:

  • ๐Ÿ“ข None of this should be taken as financial advice.

  • โš ๏ธ Past performance is no guarantee of future results!

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