A short hedge is an investment strategy used to protect, or hedge against the risk of a declining asset price in the future. A short hedge involves short selling an asset or using a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.
Perpetual contracts are an evolution of futures contracts, which are derivatives used to trade assets at predetermined prices in the future. Perpetual contracts operate similarly to futures contracts with the key distinction that contracts do not have an expiry date. Most current implementations of perpetuals do not involve actual exchanges of assets but are settled using cash or stablecoins.
A short position in a perpetual contract anticipates a bearish outlook and generates profits when the market price of the asset declines below the entry price. A short position is analogous to short selling on the spot, which involves borrowing a security whose price you think is going to fall and selling it on the open market. Your plan is to then buy the same stock back later, hopefully for a lower price than you initially sold it for, and pocket the difference after repaying the initial loan.
For example, let's say a stock is trading at $50 a share. You borrow 100 shares and sell them for $5,000. The price suddenly declines to $25 a share, at which point you purchase 100 shares to return the shares you borrowed, netting $2,500.
The protocol uses perpetual swaps for short positions which are collateralized using debts on the underlying. The costs for the position include the interest rate on the debt and the funding fees of the short position. The underlying itself is lent out while being used as collateral to cover the position costs.
The protocol uses a combination of the following strategies to generate interest and hedge downside volatility:
The staked asset is added to a lending protocol to access USDC debt on the staked balance. Using debt enables the protocol to maintain a long exposure to the asset in case the price starts rising. The USDC is used to collateralize the short position using perpetual swaps. The most important parameter for this step is the LTV of the debt. The debt size will only be a small fraction of the collateral size and the leverage on the short position depends on the fraction of the debt. The algorithm ensures that the LTV of the position never crosses a safe threshold that has an additional safety margin to prevent the liquidation of the collateral. Furthermore, the shorting strategy ensures that the debt position is eliminated before the LTV of the position reaches the safety threshold.
The USDC acquired as debt is used to open the short position with 4x leverage at the price floor. With a debt value of 25% leveraged 4x, the entire asset amount can be covered using the position. The short position captures the payoff required to hedge the asset at the price floor. In a falling market, the debt position becomes more at risk, while the short position becomes profitable. One of the following 2 scenarios could play out while the position remains open:
- The user redeems their crTOKENs before the short payoff becomes greater than the debt value. In such a case, the position is closed once the user withdraws their stake, the collateral from the short position is repaid as the debt, and the realized payoff is added to the market value of the asset (which is sold) to provide the price floor to the user
- If the payoff of the short position becomes greater than the value of the debt, then the position is partially closed to realize the payoff used to repay the debt. Once the debt is repaid, the staked asset is reacquired and the collateral of the short position adds to the position equity needed to construct the payoff of the price floor.
If the user doesn't happen to redeem their crTOKENs below the floor, the position is closed at a price slightly lower than the price floor and the debt is repaid to reacquire direct access to the staked asset.