No Bullshit Guide to Yield Farming

Aug 22, 2022 • 3 min read

Here we tell you the most important things & all the naked truths you need to know about yield farming

Yield farming is a great way to get returns by providing liquidity to AMMs in 50:50 proportion. For example, in an AMM you can provide liquidity on ETH - USDC pair for 0.3% fee per tx. Think of it as acting as market maker for people who would like to swap one token for another. It is great way to get yield, because you will be paid for each transaction that happens within the pool. However, it does come with some warning labels discussed more below

In return of providing the liquidity in 50-50 proportion, investors earn fees that are paid by AMMs users when exchanging tokens. So, when someone wants to exchange their token for another token, a percentage of it is cut to pay fees to liquidity providers. Protocol then earns a portion of fees earned by investors and provides reward tokens to incentivize liquidity
AMMs are paid in the token pair itself plus some reward token depending on the protocol.
Note that without the rewards and transaction fees, investing in AMM (liquidity pool) will always result in impermanent loss when compared to other strategies i.e. holding in wallet or staking. As such, it is very important to pay attention to the rewards and fees that you are getting from the pool.

High volatility pairs yield farming: While not advisable, the high fees are usually more than enough to offset low liquidity and big negative movements in prices. One example of high volatility pairs would be gaming tokens against $BNB. You can minimize potential impermanent loss by studying the correlation between the two assets–ideally you want to invest in pairs with high positive correlation to each other.
Stablecoin pairs yield farming: This type is advisable and investors need to consider using Uniswap V3 for this type of yield farming to maximize their return. For example, USDT - USDC pair.
Anchored pairs yield farming: This type is advisable and also, consider using Uniswap V3 for this type. For example, stETH - ETH or stMATIC - MATIC pairs.

When you expect assets’ price to remain within a certain range. Remember that doing yield farming is essentially a strategy that sells volatility—you won't benefit much when there is sharp up or down movement of prices.
When there are high liquidity and highly traded assets. Since your profit comes from fees paid when others exchange assets, the more people trade the assets the more fees will be paid.
It is better when there is a reliable auto compounder of the reward tokens. Auto compounder protocols will automatically collect and re-invest rewards you gain from providing liquidity. This will boost the return of the LP.
Most importantly, when you are NOT bearish about the tokens: Yield farming's potential impermanent loss is severe in price downturn scenarios, but relatively mild even if unhedged if remains within range (best case scenario) or bullish (second best scenario)

Yield farming payoff is equivalent to combining a short call option and a short put option.
The negative gamma is modeled as impermanent loss.

When you expect volatility of assets in either direction (up or down), it means that the assets are usually not suitable for yield farming.
When there are only assets with very low liquidity. This is because low liquidity means no one is trading the asset, hence low transaction fee will be generated.
When there is a better alternative to yield available. It is more preferable to choose the better available option. For example if you can lend your assets for a higher APY.

One way to eliminate impermanent loss is adding convexity to your investments, such as power perpertuals or Hedge with options.
One example of power perpertuals is Squeeth that can be used to add convexity to ETH-USDC LP.
Hedge with options means that when asset price move up you could buy delta*underlying to offset the impermanent loss. But, this method requires active management by the investor.
You can also consider using Thorchain, which has impermanent loss insurance. Thorchain’s ILC works by subsidizing you when you withdraw your deposit from the liquidity pool. If the impermanent loss is greater than the fees and incentives then you will be subsidized the difference.

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