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Last active Jun 21, 2022
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Getting a 2:1 or greater risk-reward ratio on LN node and channels

Getting a 2:1 or greater risk-reward ratio on LN node and channels

WIP

Lets say a user wants to spin up a node with 0.1 btc, open a few channels, and generate routing fees.

How do they calculate a risk/reward ratio (RR) that makes economic sense?

What else can they do to improve the calculation, such as compartmentalising risk into discrete chunks which can be evaluated independently?

Risk/Reward Ratio

The simplest form of RR is (net profit)/(cost of maximum risk)

Commonly accepted reward ratios are 2:1 or 4:1. That is 2-4 times maximum losses.

Downside Bias

For the purposes of this post we are only considering downside risk, we ignore upside gains and re-calculate risk at a higher price if we need to.

Node Assumptions

10m sats allocated to multiple channels, with incoming capacity, could generate 10k sats a year in routing fees.

Components

Net Profit

  • income from routing fees in sats, converted to fiat value

Cost of Maximum Risk

  • cost of 0.1btc in fiat terms
  • cost of insurance against loss in value for 0.1btc
  • cost of hosting a node for a year in fiat terms
  • cost of opening channels in sats, converted to fiat value

Perfect hedge

If a user can insure against value loss for bitcoin purchase, through a mechanism such as:

  • a corresponding short on perpetual futures, or
  • staggered buys at lower prices on spot exchanges, or
  • some other mechanism

they can eliminate the initial capital cost of the bitcoin from risk/reward calculations because the risk would be covered elsewhere.

If they can remove hosting costs too, they can eliminate additional components of the risk calculation.

Remaining costs to insure against are tx-fee related and 2:1 RR starts to become feasible.

Other steps are also required, such as improved security of the wallet itself, with a hardware wallet. This can also allow for multi-sig capabilities, and further eliminate risk.

Go short 0.1btc on perpetuals

This is a hedge taking the opposite position on a futures market when the 0.1btc is purchased on spot.

If bitcoin price goes down, the short can be closed in profit for more bitcoin to compensate loss in fiat value.

Pros

  • can be purchased in bitcoin

Cons

  • 3rd party custody
  • liquidation if not sub-1 leverage
  • add margin if price goes up, add to position

Or buy percentage more btc at lower prices

This is less risky hedge, where a user bets on being wrong 4+ times, by placing buys at lower prices to increase their position to compensate for the loss in fiat value.

Pros

  • fiat-based
  • local exchanges, P2P trades
  • can keep cash earning interest and spend when needed
  • catch flash crashes if market orders

Cons

  • if fiat with 3rd party, no interest income, inflation risk

Examples:

  • 20% drop in fiat value means an additional 0.02 bitcoin need to be purchased

Howto

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