Julio Rubio

10/8/2022

According to TVL data, Uniswap is the biggest DEX with $6.3b locked. Its latest version (v3) opens a new paradigm in the liquidity provision ecosystem, allowing liquidity providers to provide concentrated liquidity. In this post, I will quickly explain the token balance behavior inside and outside the lp range and draw similarities to plain vanilla options.

First, let us have a look at the behavior of token balances inside the range. Let us take the Ethereum-USDC pair as an example, where Ethereum is the underlying asset and USDC is the quoting asset, the token balances inside the range behave as follows:

- As the price of Ethereum increases, the amount of Ethereum decreases, and the number of USDC increases
- As the price of Ethereum decreases, the amount of Ethereum increases, and the number of USDC decreases

This happens as long as the price of the underlying is inside the range. Once the price goes beyond the range, the token balances behave as follows:

- 100% Ethereum to the downside
- 100% USDC to the upside

Bellow, the token behavior is plotted for the range 950 to 1050. As seen in the plot, token balances change symmetrically inside the range and stay constant outside the range.

After this simplified explanation of how token balances work in v3 lp positions, let us build an option with it.

If we set up the narrowest range possible (1 tick) around the current spot price and the price moves, an almost instant swap from one token to the other would take place depending on the direction of the price movement. If above the range, we would have USDC, and if below the range, we would have Ethereum. The jump from 100% USDC to 100% Ethereum would happen in a very small price range (3 or 4 dollars around the current spot price). As a consequence, we can ignore the range since the time inside the range is very small.

As a result, we have created a short put or covered call option that behaves like an option but with some flaws. I call it the uniswaption because it has a uniswap lp component, a perpetual swap component, and an option component.

Here are the flaws:

- The range makes the option payout imperfect
- There is no premium
- Liquidity pools on Uniswap run as long as there is liquidity on them. Therefore we can say that the uniswaption is a perpetual option since it has no maturity and theoretically runs to infinity.

There is no real utility on trading the plain uniswaption since there is no premium, and therefore no possibility to profit from it, but understanding its behavior of it, helps us understand how to hedge the risks accordingly, which in this case could be done by buying a simple put option. For bigger ranges, the uniswaption fundamentals still exist, but the balances inside the range play a bigger role and present new hedging complexities.

*This post is intended for educational purposes only and does not constitute the provision of investment advice, and is not intended to do so. The author and Primate Capital specifically disclaim all liability for any direct, indirect, consequential, or other losses or damages arising from any reliance on this article. Trading cryptocurrencies, derivatives, and structured products may involve a high degree of risk and may not be appropriate for all investors. Under some market conditions, it may be impossible to liquidate a position. Investors may suffer substantial losses and even lose the entire amount of their investment.*

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