The DeFi Turkey Problem: How to Avoid Being the Sucker
Learn to Avoid the Fate of the Turkey and Profit from Black Swans
In his seminal book The Black Swan, author and trader Nassim Taleb describes the Turkey Problem as a central parable for correctly understanding probabilities in the market and, to use Taleb’s words, avoid being the sucker.
The parable follows the fate of a turkey, who, day by day, is getting fed by a friendly human allowing him to grow a little bit bigger (and happier) every day. One day, the Wednesday before Thanksgiving to be precise, something unexpected happens — boom! — the turkey suddenly dies.
For anybody who’s been in the crypto markets for longer than a hot second, the above chart should look eerily familiar.
How many projects and coins have been cheered on by pundits on X as the next big thing, only to follow the fate of the turkey and literally go to zero?
We don’t have to look far back in history to find a suitable example:
LUNA had a wonderful run up in 2021 & 2022 — with its price rising continuously to a top of $100 and a market capitalization of over $100 billion. The Turkey was fat and happy. Until one fateful day something unexpected happened and the coin lost 99% of its value. Ouch.
LUNA is not the only example of the Turkey Problem wiping out unfathomable amounts of crypto wealth.
Unfortunately, many of the current trading strategies in DeFi, a topic dear to our hearts here at Hermetica, are prone to suffer from the same problem of sudden and debilitating losses.
The Turkey Problem in DeFi
The two most prevalent trading strategies in DeFi today are:
- Liquidity provisioning in Automated Market Making (AMM) protocols
- Call overwriting
Both of these strategies are structured so the user makes a small amount of money most of the time, but can incur massive losses when tail-risk events transpire.
Let’s take a closer look.
- Automated Market Making (AMM)
A user providing liquidity for an AMM protocol usually deposits two assets in a pre-defined ratio into a pool. The user then “makes” the market and receives the trading fees as compensation in return. Sounds good, doesn’t it? So what’s the catch?
There is one major issue with the way these AMM protocols function: The user essentially enters a short volatility trade, betting that prices will maintain a specific range.
The result is a strategy that makes a small amount of money (from trading fees) most of the time, but can suffer potentially unlimited losses if the price of one of the assets in the pool either rises or falls significantly.
2. Call Overwriting
Call overwriting, also known as a covered call, is a derivatives trading strategy that collects a premium by selling short dated out-of-the-money call options while holding the underlying spot asset.
For example, a user could deposit 1 BTC trading at $44,000 and the strategy would sell a one week $50,000 call option against it to collect a few hundred dollars in premium.
The strategy works wonderfully 95% of the time, producing a consistent return while the Bitcoin price doesn’t cross above the strike price of the call option. But in the rare instances where Bitcoin’s price rips higher (in our example above $50,000) the strategy will incur unlimited losses.
How to Avoid Being a Turkey
At Hermetica we have made it our mission to create trading strategies that make it categorically impossible to suffer the fate of a turkey.
The simple yet highly effective solution is to only engage in trading strategies with defined, limited risk.
All of Hermetica’s vaults execute strategies that follow this principle and only risk a small percentage of the vault balance every epoch. The Hermetica Earn vault, for example, only risks 1% every month.
Structuring our strategies this way means that no matter what unexpected surprise the market has in store, the capital in the vault stays protected. There’s simply no scenario where the vault could fall victim to the Turkey Problem where massive losses lead to a crushing wipe-out.
Our users will never be a turkey.
How to Profit from the Turkey Problem
Categorically and systematically avoiding being a turkey is our baseline. But what if there are ways to not only avoid the problem but actually profit from it?
The hedge fund Universa, which was co-founded and advised by Nassim Taleb, has built their whole business around this one question.
Their impressive returns of over 4,000% in 2020, a year where the Covid crash made most portfolios look as happy as a turkey on Thanksgiving day, speaks to the fact that profiting from Black Swans is not only possible but potentially highly lucrative.
The best part of Universa’s performance is that the high returns were generated at a time when the rest of an investor’s portfolio was likely massively in the red. Or in other words, a tail-risk hedge a la Universa is the perfect vehicle to protect a portfolio that is heavily long the market.
What if this kind of strategy was not reserved to ultra high net-worth individuals and institutions (the only entities that can get an allocation to a hedge fund like Universa) but instead was made available as an easy-to-use, non-custodial DeFi vault?
What if there was a set-it-and-forget-it type of product that allows you to effectively hedge your long Bitcoin exposure? Not only protecting your portfolio’s USD value in a market crash, but actually adding satoshis to it?
What if a massive Black Swan induced crash like we saw during Covid could be a pleasant and profitable experience?
Get on our waitlist at hermetica.fi if you want to be among the first to get access to our ground-breaking new DeFi products as we release them.
