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Once we combine our Uniswap LP position with the borrowed assets, we end up with is a short-gamma position similar to a short straddle. This position would lose money if the price of the volatile asset shifted dramatically in either direction. This is also sometimes referred to as “impermanent loss.”
Here is a graph of what this impermanent loss looks like for a hedged uniswap LP position (the graph does not include any earned fees). As you can see, if the price jumps 100% we’ll suffer roughly a 10% loss.
To limit losses, our strategy automatically rebalances the portfolio if the price shifts around 8% in either direction, limiting our losses to about .08% for each interval. As a result, we can eliminate Impermanent Loss in exchange for discrete losses incurred as part of rebalancing. As long as our rebalancing costs are lower than the fees we receive from providing liquidity, the strategy will remain profitable. The worst case scenario for the portfolio is when prices jump back and forth within a short period of time forcing us to rebalance multiple times. This can lead to short periods of negative performance.