Impermanent Loss at Your Lemonade Stand
Simplifying Impermanent Loss for All to Understand Pt. 1
Since it seems impermanent loss was a hot topic I thought I would spend some time diving in a bit deeper. The goal of my writing is to take complex problems experienced in markets and bring them down so we can all understand them. For those that have questions, feel free to leave a comment and we can discuss them below.
We have a lot to talk about so let's get started. Impermanent loss in its simplest form is the leaving of $ on the table as you are a provider of the more desirable asset in a liquidity pool. What does this mean? This means you open up a lemonade stand on a hot July day. At the beginning of the day, you have $100 and 100 cups of lemonade at $1 a piece. As the day goes on your lemonade stand is a hit, and people continue to want more and more. This drives your lemonade cup price to $1.50 as you slowly run out of supply. At the end of the day, the price of lemonade is $1.50 and you are left with $225 because you sold all of your lemonade to the market at an avg. of $1.25 / cup. If you think of your lemonade stand as a portfolio, you are now holding $225 and your asset is trading at $150 (100 cups of lemonade at the market price of $1.50 a cup), meaning you left $25 on the table (original $100 + $100 of lemonade inventory + lemonade profit — ((the current trading price of lemonade)*(starting inventory of 100 cups)) vs. holding all of your lemonade.
While you did still earn a decent return on your $, you could have done better, but how?
Let’s take a look at what is actually happening, I grabbed this chart from whiteboardcrypto as I am a visual learner and find it very helpful to look at charts:
By looking at this chart let's make the assumption we are looking at price change in our Lemonade. In an LP there is a pool of assets, our lemonade stand is no different we showed up with $ and lemonade, remember we are looking to simplify things here. By looking at the chart, we notice that large movements in the underlying price of our lemonade will create this “impermanent loss” phenomenon. For example, if tomorrow's lemonade price is $5 and we sold all of ours at a price of $1.25 then we are leaving $3.75 on the table per cup. That is quite significant, and for that reason, we need to get clever with our thinking.
Here comes the fun part. In the world of maximizing profits (which is what we are trying to do), we need to get our avg. cup sold as close to the current market price as possible. This will require some rebalancing of our lemonade stand. Imagine this, if the price of lemonade were to go up throughout the day at a steady pace that isn’t a problem, we can call someone to run to the store for us, and we pay them with some $ to buy more lemonade. This is called delta hedging, I know fancy… However, if the price of lemonade were to move in a very fast manner, we may run out of supply quicker than we can call someone to go to the store. This presents a problem, this event is gamma risk which we will dive into in part 2.
For now, let's talk about delta and the current problems in crypto for this. In the current environment, we are sellers of lemonade at a park. This park is the busiest part of the city and for that reason, we want to be there selling our lemonade. The problem is, the store to buy more lemonade happens to be a 30 min drive away. This means there is an hour delay in which we can get more inventory to supply at higher prices. We find ways to make it work but know that if prices change too fast there is no way we will be able to capture this movement and are exposed to “gamma risk”. In crypto this is seen in the forms of being an ETH/USDC LP and using dYdX to hedge your delta. Bear with me as this might be a bit more advanced, but it is important. All is well when the price of lemonade is steady, we sell our lemonade on Uniswap through our LP and go to dYdX (store) to buy more lemonade to sell.
For the time being, we make the trip to the store but continue to think about how to optimize this problem in markets. The real risk to this equation is found in running out of lemonade to sell, before buying more lemonade at the store at a higher price just to see prices come back down and losing some hard earned $ on the day.
I’ll leave it there for now and dive into pt. 2 which will feed off of this concept and how to optimize our lemonade gains.
