Rebalancing Mechanisms
Last updated
Last updated
As a strategy creator, there are certain factors that you need to consider for creating liquidity provisioning strategies that earn you the best yields. One of these factors is the rebalancing mechanism. This is a detailed guide on active and trailing rebalancing.
After selecting a market mode, you have to choose a rebalancing mechanism. Based on your expertise, market understanding, and risks associated with each rebalancing mechanism, select one of the two rebalancing types.
Active rebalancing adjusts your liquidity position within the market’s price range by adjusting the distribution of tokens in your liquidity pool. It ensures your position is always within the active price range to keep earning fees and yields from trading volume.
Let’s understand this by an example of a pool ETH/USDC. ETH has a volatile price and it could go up or down.
When the price of $ETH drops below the minimum price range, your position will go out of range and will stop generating fees and yields. A51 will actively rebalance your position by converting your $USDC to $ETH partially since its price decreased to bring your LP position back to the range.
When the price of $ETH goes above the maximum price range, your position will go out of range and will stop generating fees and yields. A51 will actively rebalance your position by converting your $ETH to $USDC partially since its price increased to bring your LP position back to the range.
When the price of tokens in a liquidity pool diverges from the price at the time of deposit, it incurs a loss to the LP called Impermanent Loss (IL) or Divergence Loss.
If you withdraw or rebalance your liquidity position at these prices or when your position is out of the market’s current price range, it becomes a permanent loss.
It especially happens with the volatile token prices. So, pools with one or both volatile tokens are more prone to IL. Since the prices fluctuate frequently and often significantly, the potential loss is higher.
Trailing rebalancing works by trailing the market price before executing the rebalance. It does so to wait for the market price to come back to the previous range as it is usually for a very short time. It is also to avoid unnecessary impermanent loss by quickly swapping tokens in the pool and keeping the LP position in the range. It makes sure your position is always within the active price range so that you can keep earning fees and yields from trading volume and avoid IL as much as possible.
Let’s understand this by an example of a pool ETH/USDC.
When the price of tokens in a liquidity pool diverges from the price at the time of deposit, it incurs a loss to the LP called Impermanent Loss (IL) or Divergence Loss.
If you withdraw or rebalance your liquidity position at these prices or when your position is out of the market’s current price range, it becomes a permanent loss.
It especially happens with the volatile token prices. Since, trailing rebalancing works by trailing the market price instead of rebalancing the position right away. Therefore, it prevents unnecessary losses.
After selecting the rebalancing mechanism, set a rebalancing frequency, a price range, and a price deviation threshold.
A51 doesn’t limit you to a fixed price range or ratio while creating a strategy.
You define the minimum and maximum price range around the current price. You can make it in a custom ratio according to your assets and investment mindset.
The price deviation threshold is the minimum and maximum price below and above the price range you set.
In ALMs, as soon as the price goes out of range, it rebalances.
But with A51 it’s different. When you set a price deviation threshold, you guide A51 at what price rebalancing of your liquidity position should happen. Here’s how it benefits:
It is a high-level customization that helps you minimize unnecessary losses.
It also prevents spammed rebalancing during market volatility.
As a strategy creator, you can speculate if the market bounces back to your main range until your set threshold of resistance or support.
Determine how many times you want the protocol to rebalance your liquidity position before it pauses rebalancing.
This helps you make a deterministic decision by rethinking your strategy after the set number of rebalances as the market may change in nature.
It also helps prevent changes in your liquidity position too many times thus protecting you from bigger losses which usually happen in active rebalancing.
By customizing these factors, you are guiding A51 to rebalance when these conditions are met. It requires you to stay updated with the market, especially how your deposited tokens perform to make informed decisions.
There are certain ways you can prevent the risk of impermanent loss:
Closely monitor the token prices for minor or significant price fluctuations and keep your position within the current market price range.
Choose the right market mode for your strategy which requires you to actively observe the market piece trends of your assets.
Set an optimal price range and price deviation threshold depending on the volatility of the assets.
Select stable tokens or pools with stable tokens to deposit your liquidity as their price and pool ratios remain stable hence less prone to IL.
In the case of tokens with volatile prices, provide liquidity in wider ranges instead of narrow ranges so that your position doesn’t go out of range with every price fluctuation. Narrow ranges do yield better returns as compared to wide ranges but they come with a price of unnecessary IL.
Please note that this is not a financial advice. Head over to A51 Finance’s Discord community to have experts’ advice on choosing or creating the right strategies for your liquidity and preventing IL as much as possible.
