1/So I tweeted yesterday about how providing liquidity in defi exposes you to impermanent loss, which is basically just negative PnL from short gamma. But what is gamma?

2/ Gamma is the partial derivative of the delta with respect to the underlying. In more simple terms, it is how much your delta changes when the underlying moves by 1%. (Delta is how much your position changes when the underlying moves by 1%)

3/ So now that you know what gamma is, what happens when you are short gamma and the prices moves in one direction? Well, your delta will increase when the prices goes down and your delta will decrease when the price goes up.

4/ This is obviously bad. It means that you hold less of the underlying when the price goes up and more of it when the price goes down. So you want to be long gamma so that you gain exposure to positive moves.

5/ Now why are you short gamma when you are providing liquidity on a dex? When you provide liquidity on a dex, you are deploying capital to buy more of the asset when the price goes down and sell more of the asset that goes up.

6/ This means that your delta increases when price goes down and delta decreases when price goes up, hence short gamma. Are you being compensated for this? Yes because if the price fluctuates in a narrow band LP makes profit from the fees.

7/ Conclusion: Providing liquidity on a dex should be considered to be a short gamma position, which has to be monitored and actively managed. Dexs should try to penalize liquidity providers that actively manage their position so that everyone who is providing liquidity

8/ is on the same terms and have equal return/risk profile. Dexs that structure it in this way will enable retail to become market makers and compete on the same terms as Citadel or Alameda on these defi platforms.