1️⃣Uniswap's Inherent Hedging
By definition, hedging is to take an offsetting position in an asset or investment that reduces the price risk of an existing position. A hedge is, therefore, a trade that is made with the purpose of reducing the risk of adverse price movements in another asset.
If you take a deep look into the dynamics of the Uniswap algorithm, you'll realize that the Uniswap smart contract is dynamically hedging the pool whenever there is a movement in the price of the underlying assets. As the price moves in one direction, the protocol increases the reserves quantity of one asset and decreases the other. Uniswap's algorithm is therefore replicating the negative delta of long put options on the assets it holds as reserves through dynamic hedging.
Uniswap’s Embedded Options
Since Uniswap is dynamically hedging an exposure to hypothetical long put options on its reserves, then it is essentially always taking the opposite trade of long put options on its reserves. Therefore, an LP, at any point in time, is holding short put options on its reserves. We can therefore think of Uniswap pools as holding embedded short put options, which liquidity providers expose themselves to when they add liquidity to a pool.
The difference between Uniswap’s embedded options and tradFi options is that traditional options have:
An expiration date
A one time premium, and a strike price that can be different from the current price.
An Uniswap embedded option is perpetual, its strike price at the time of sale is always the current price, its premiums payments are variable and paid in perpetuity, and it is written for an infinite number of units of the asset. That means its delta can increase to infinity.
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