Impermanent Loss for Liquidity providers
What is Impermanent Loss and why you should care about it?
Whether you’re a degen or an aspiring liquidity provider, you should understand Impermanent Loss.
You will get to fully appreciate tomorrow’s thread about Smar DEX $SDEX because they’re providing great opportunities for liquidity providers.
When you’re yield farming you’re providing tokens to a liquidity pool (or LP) for an Annual Percentage Rate (or an APR ) to make more money.
By providing liquidity in a pool, you will get to face this kind of loss.
♦What is Impermanent Loss?
It’s the risk of a price change to your deposited assets in the liquidity pool. It’s the risk of change to your deposited assets. This price change can be positive or negative.
Altcoins are exposed to more than 10–20% of losses and gains per day in liquidity pools. The bigger the change on a token, the more there will be a loss.
Only liquidity providers (or LPers) face this kind of loss!
♦Why does this happen?
Impermanent loss happens because of the way automated market makers (AMMs) are designed. Make sure you understand what AMMs are before diving deeper! Here’s an article about it.
So like SushiSwap and UniSwap.
This happens because these decentralized exchange (DEXs) depend on the automated market makers to decide the prices automatically. The swap is short-sighted and instant. It’s not looking at an order book to determine the best-fit price.
♦How does Impermanent Loss happen?
Here’s a short breakdown, as short as I can go.
Understand that tokens are deposited in pairs. If you’re depositing some ETH & USDT to ETH/USDT pool, it’s split between the two, usually 50/50. Half to ETH’s pool and half to USDT’s pool. The impermanent loss is actualized when you claim back your tokens after a change in price action.
Example 1:
If ETH was for 100$.
- You chose to provide 1ETH and 100USDT, which is a total of $200.
- Liquidity pool has 10ETH and 1000USDT so the total in pool is $10,000.
What you put in the pool represents 10% of the total liquidity pool.
- 📈ETH goes to $400.
- Arbitrage traders will start buying more ETH for USDT. AMM is still making sure there’s $10,000.
- Liquidity pool ends with less ETH (5ETH) and more USDT(2000USDT).
You own 10% of total pool, so now you have: 0.5 ETH and 200 USDT, which is a total of $400. You started with $200 and now you got $400.
Yes you made more, but if you had HODLed (held the tokens in your wallet) you would have had 1ETH and 100USDT for a total of $500! This is where the loss happened.
- 📣However there’re still trading fees not accounted for.
You might get $200 from trading fees, so total will be $400 plus $200. That is a total of $600. This is $100 more than HODLing. But if you end up getting say 95$ from trading fees, then your impermanent loss is 5$.
♦How to avoid Impermanent Loss as a liquidity provider?
There are ways and cases to avoid the loss.
- Choosing stablecoins and wrapped tokens.
- Calculating the risks.
1. Choosing stablecoins and wrapped tokens.
The more stable a pair is, the less loss you’ll face.
Providing liquidity to stablecoins lowers the risk because price volatility rarely ever happens. Wrapped tokens (WBTC, WETH, WBNB) maintain a stable peg to their originals. However, you’ll still have to stay vigilant for any depegging.
2. Calculating the risks
If the price increased 25%, you’ll face 0.6% unrealized loss, meaning:
- HODLing would have made you 0.6% more
- unrealized loss because it’s still in the pool
- becomes realized aka impermanent loss once you get back your tokens
The more the price changes, the less profits you make.
Example 2:
- Liquidity pool has 10ETH and 1000USDT so the total in pool is $10,000.
Same liquidity pool in example 1 but ETH went down 50%. 1ETH = 25.
- Now the liquidity pool 20 ETH and 500 USDT.
- You owe 10% of that, so you get 2ETH and 50USDT = $100
You lost 50% of your capital, but gained 1 more ETH.
If you decided to take back your tokens, then price went up again, you have made more for the value of ETH you got. Yes, this made it a “good” trade off, but because ETH is known and trusted.
♦Be careful
The best liquidity pools are ones with high trading volume on the platform itself with the liquidity pool and NOT in general. If you put liquidity in a pool with 0 trading volume, you won’t make any money.
High trading volume will make you good returns.
The best instances to be a liquidity provider are during boring total market price action, because of stable prices. Even when both pairs are going down — that’s better than one changing on the account of the other.
There’s always a risk of losing money. Forks might happen to the automated market maker you’re using. Old AND new protocols may have problems. So be careful with what you do. The space is always changing so keep up with the news!
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Disclaimer: This content is for educational purposes only and should not be considered as financial or any other advice. Always do your own due diligence before investing any of your money, and stay up-to-date with all crypto regulations withing your jurisdiction.
