When I was the Head of the Portfolio Management I needed to instruct my traders on level of leverage they can take to open the Perp/Futures position or hedging through Decentralized lending protocol. So to simplify their decision-making process I wrote down the simple guide to leverage management with 2 important levels: Initial leverage and a Risk limit, the level you need to start acting and reassessing your position.

Leverage can be a powerful tool for maximizing returns, but it comes with its own set of risks. Hedge funds, known for their sophisticated strategies, employ robust leverage management frameworks to navigate the complexities of leveraged positions. Here are five tips inspired by my hedge fund practices that can help you manage leverage effectively:

1. Understand Your Position Types: Collateral or Credit Side Risk

   • Collateral Side Risk: When using volatile assets as collateral (e.g., ETH, BTC) and stable assets as margin instruments (Stablecoins like USDC, USDT), understanding the initial Loan-to-Value (LTV) and Liquidation LTV is crucial.

   • Credit Side Risk: When stable assets serve as collateral, and debt is disbursed in volatile assets (e.g., USD as base, ETH as debt), careful consideration of initial LTV and Liquidation LTV is necessary.

2. Know Your Instruments: Repos, Derivatives, and More

   • Be well-versed in a variety of leveraged instruments, including repos, reversed repos on decentralized lending protocols (Aave, Compound, Radiant), and derivatives such as futures and perpetual swaps on both decentralized (dYdX, Aevo, Hyperliquid) and centralized platforms (Binance, OKX).

3. Set Defining Points for Decision-Making

   • Establish clear defining points according to the marginal policy of the platform. Key indicators like VaR (Value at Risk) at 1-week and 24 hours with confidence intervals should guide decisions.

   • For collateral side risk, use VaR 1 week 99% for initial LTV and VaR 24 hours 99% as a risk limit.

   • For credit side risk, leverage VaR 1 week 1% for initial LTV and VaR 24 hours 1% as the risk limit.

4. Calculate Initial LTV and Risk Limits

   • Leverage historical data for Value at Risk (VaR) computation. Employ a non-parametric approach with confidence intervals based on the historical distribution of returns.

   • Portfolio Managers should use the Value at Risk metric to calculate initial LTV, incorporating Liquidation LTV and the appropriate VaR.

5. Portfolio Manager's Role in Decision-Making

   • Acknowledge that the number of parameters affecting LTV/Leverage is vast and may not be fully algorithmized. The Portfolio Manager's expertise, in conjunction with risk limits, should guide the final decision-making process.

   • Base decisions on the robustness of estimates derived from the daily amplitude data, considering returns from High to Low.

Positions are exposed to the collateral side risk when the volatile assets are used as the collateral for the leveraged position (You deposit your coins and take leverage in stablecoins). The typical position is:

• Base asset of the portfolio: ETH

• Long: ETH Deposit on Aave

• Short: USDC Debt on Aave

• Key parameters – initial LTV and Liquidation LTV

The 2 defining points are as follows:

• VaR 1 week 99% – indicator for the initial LTV and cushion to liquidation price

• VaR 24 hours 99% – risk limit indicator for the call to action:

  • Increase collateral up to the current VaR 1 week

  • Decrease leverage up to the current VaR 1 week or fully liquidate

Initial LTV is calculated:

Example:

• ETH – base asset

• USDC – debt asset

• ETH VaR 1 week 99% = -40%

• ETH VaR 24 hours 99% = -20%

• Liquidation LTV = 80%

• Initial LTV = (1-40%)*80% = 48%

• Risk Limit = (1-20%)*80% = 64%

Positions are exposed to the Credit side risk when the stable assets are used as the collateral and debt is disbursed in volatile asset for the leveraged position. It means that we have short position in volatile asset. The typical position is:

• Base asset of the portfolio: USD

• Long: USD Deposit on Aave

• Short: ETH Debt on Aave

• Key parameters – initial LTV and Liquidation LTV

The 2 defining points are as follows:

• VaR 1 week 1% – indicator for the initial LTV and cushion to liquidation price

• VaR 24 hours 1% – risk limit indicator for the call to action:

  • Increase collateral up to the current VaR 1 week

  • Decrease leverage up to the current VaR 1 week or fully liquidate

Initial LTV is calculated:

Example:

• USDC – base asset

• ETH – debt asset

• ETH VaR 1 week 1% = +35%

• ETH VaR 24 hours = +15%

• Liquidation LTV = 80%

• Initial LTV = 80%/(1+35%) = 59%

• Risk Limit = 80%/(1+15%) = 69%

Positions are exposed to the Credit side risk also when we us stable asset as a margin for short position in volatile instrument futures or perpetual swap to hedge long spot position in the same asset (or correlated one). The typical position is:

• Base asset of the portfolio: USD

• Long: ETH

• Short: ETH:USDT Perpetual swap with USDT margin

• Key parameters – initial Leverage and Liquidation threshold

The 2 defining points are as follows:

• VaR 1 week 1% – indicator for the initial Leverage and cushion to liquidation price

• VaR 24 hours 1% – risk limit indicator for the call to action:

  • Increase collateral up to the current VaR 1 week

  • Decrease leverage up to the current VaR 1 week or fully liquidate

Initial Leverage is calculated:

Example:

• USD – base asset

• ETH – long spot and short ETHUSDT Perpetual

• ETH VaR 1 week 1% = +35%

• ETH VaR 24 hours = +15%

• Liquidation threshold = 0%

• Initial Leverage = 1/35% = 2.8x (35% from Liquidation)

• Risk Limit = 15% from liquidation

By adopting these hedge fund-inspired tips, you can enhance your leverage management strategy, making more informed decisions and navigating the complexities of leveraged positions effectively. Remember, knowledge, and prudence are key when wielding the power of leverage in financial markets.