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.

Why are some pools good 🐶 and other pools bad 😈?

The answer comes from breaking down LP profits into:

1. Price changes 📈

2. Fees collected 🎟️

By comparing LPs to options, we discover parallel insights — let's explore! 🧵

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Price changes

• ⬆️ Price up: positive return

• ⬇️ Price down: negative return

• ⤵️ Payoff determined by delta (Δ) & gamma (Γ) of LP position

Why use options terminology (Δ & Γ) for LPs?

Hint: that payoff looks awfully like a short put option!

Fees collected

Fees collected are determined by the theta (Θ) of the LP position.

• 🕒 Θ: Rate of time decay (dV/dτ)

• 💰 dV = fees collected

• 🧊 dτ = 1 block

→ Θ = fees per block 🤯

• ✅ Near the money: Θ > 0

• ❌ Far the money: Θ = 0

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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 🧮

• Fees collected ⇔ options premia 👇

• ⬆️ options premia ⇔ ⬆️ IV

Results match TradFi! 👇

• 🐶 Good pools (green dots): lie below the line, compensated by high fees given volatility ("IV > RV")

• 😈 Bad pools (pink dots): lie above the line, not compensated enough ("IV < RV")

(Dot values are summed returns from LPing)

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How do price changes and fees affect returns?

• ⬆️ Price → ⬆️ LP returns (since fees are always positive)

• ⬇️ Price → ⬆️ LP returns if Θ dominates

• ⬇️ Price → ⬇️ LP returns if Δ & Γ dominate

Let's define "dominance" so we can analyze pool returns! 👇

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

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

(fees & payoff expressed as percentages)

Meaning:

• 💪100% Θ dominance → fees drove 100% of LP returns

• 🤕0% Θ dominance → 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 Θ dominance next to cumulative returns, we find:

• 😔 Bad days (negative returns) driven by price movement

• 🥳 Good days (positive returns) driven by fees

Breakdown of positive & negative returns confirms that good pool Θ dominance > bad pool Θ dominance:

• 😔Bad days: 28% ($ENS) > 22% ($UNI)

• 😊Good days: 59% ($ENS) > 50% ($UNI)

The good pool also had a higher proportion of good days:

• 🤩ENS: 63% (272/433)

• ☹️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)

📣 Key Insights:

1. LP = short option payoff

2. Δ, Γ, and Θ affect LP returns

3. LPs compensated when IV > RV

4. Good days/pools driven more by fees than by price changes

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Disclaimer:

• 📢 None of this should be taken as financial advice.

• ⚠️ Past performance is no guarantee of future results!