Introduction to Impermanent Loss

One of the experiences liquidity providers share the most is impermanent loss. The money lost as a result of the change in price after you deposit tokens into a liquidity pool constitutes your temporary loss.

You, the liquidity provider, are impacted by this loss, but so are a lot of other people. When we decide to stake our tokens to earn trading fees on DeFi, it's a complex situation for which most of us had no exposure.

To comprehend impermanent loss and how to calculate how much you actually lose, you need to apply a particular kind of examination. There are sophisticated algorithms and equations that can calculate the amount's exact decimal.

Not to worry, we’re going to break down what impermanent loss is and six possible ways to avoid it.

Automated market makers and liquidity pools

An automatic market maker (AMM) is an algorithm that continuously buys and sells assets to provide liquidity to a market. Liquidity pools are collections of capital used to buy and sell assets in order to provide liquidity to a market. These pools can be managed by AMMs or other algorithms. AMM mechanism removes the intermediaries and allows for the automation of trading.

When a trader needs to swap Ethereum for pUSD, they can come to the trading pool, put some ETH into it and take the equivalent in pUSD, minus a transaction fee (0.3%). The individuals who have contributed to the pool, or the liquidity providers, will receive payment of that transaction charge.

A liquidity pool contains a ratio of two tokens that is set by the first liquidity provider. For example, if the pool contains pUSD, which is pegged to the US dollar, and ETH, the first liquidity provider can choose the ratio of pUSD to ETH in the pool. The values of the tokens in the pool are only influenced by their relative amount and not by external marketplaces.

In the event that you want to withdraw, you will be paid a percentage of the total transaction fees collected up to that moment based on the proportion of assets you provided in the liquidity pool. Assume that the price of ETH stays the same and that the volume of trades before your withdrawal totaled 100 ETH, for the liquid providers, they will share a profit of 0.3 ETH.

How Impermanent Loss Occurs

So now we are aware of how liquidity providers profit in the ideal situation where prices are a calm candlestick. Unfortunately, there is a lot of volatility in the world of cryptocurrencies, and prices frequently fluctuate.

You've sustained an impermanent loss if the value of your token changes after you've added it to the liquidity pool.

In the example of 1 ETH is worth $100 at the time you add liquidity, if the price of ETH increases to $200, you will now be looking at an exchange rate of 1 ETH to 200 pUSD.

You'll see at this time that if you had stuck onto your one ETH and one hundred pUSD. You would have received $300, making a profit of $100. However, because you put it in the liquidity pool, you're locked with the initial price, which results in a temporary loss of 50%.

The good news is that this loss might be transient. If the price of ETH eventually drops to the level at which you deposited it, you'll come out even.

Estimating Impermanent Loss

Impermanent loss is dependent on sheet value, which means it will change until something is done. Your loss will be permanent if you choose to withdraw after a price change.

The situation now becomes interesting since the figure you receive will be vastly different from what you had anticipated.

When ETH price goes up, a window of opportunity exists for arbitrage traders to seize and purchase the token at a discount.

Since the new rate for ETH is 200 pUSD and the previous price in the liquidity pool is 100, traders can replace Ethereum and put in pUSD until the ratio reflects the new rate. This ratio is calculated using a complex formula, but you can find the precise value online using a calculator.

Remember that there are 10 ETH and 1000 pUSD in your pool. Now, using the calculator to plug in the new ETH price at 200 pUSD, we get a new ratio. 10 ETH/1000 pUSD ⇒ 7.07 ETH/1,414.21 pUSD.

The arbitrage traders, as you can see, got away with 2.93 ETH for 414 pUSD. However, you continue to have a 10% share of the new ratio. If you withdraw, you would receive $282 and 0.707 ETH multiplied by 200 and 141.421 pUSD.

Although this is still more than the $200 you began with, you would have had $300 if you had not deposited.

Take-aways

The trading fees you would have made along the road, regardless of temporary losses, were not taken into consideration in any of the calculations. The majority of people would argue that the earnings will eventually offset the price changes.

That may be the case, but we are unable to use our revenue to cover our losses. For this reason, one should only stake their tokens after careful deliberation, which should include the risk estimates indicated above. Start off modestly and just invest what you can afford to lose because a larger deposit will result in a greater temporary loss when prices shift.

So, without further ado, let’s get into some ways to avoid Impermanent loss.

  • Provide to stablecoin pairs: Provide stablecoin pairs: Stablecoins are supposedly resistant to temporary loss because their price doesn't fluctuate. Keep an eye out for any stablecoins that might devalue.

  • Avoid risky or volatile coins: Speaking of risk, tip #2 is to stay away from unstable or risky currencies. When a coin is volatile, temporary loss is amplified. Stablecoins' few price fluctuations lessen the temporary loss, but the opposite is also true. You will also sustain a significant amount of temporary loss when a coin's price swings suddenly, either up or down. Both newly issued coins and tokens with limited liquidity have a high level of volatility. New and low-liquidity tokens fall into the same group and appear to be riskier. Avoid these coins, according to tip #2, as they come with a high reward but also a high risk.

  • Provide when a coin price is low: You can try to supply liquidity during a bear market if all you're doing is making sure your temporary loss isn't impacted by the coin's decline. In this manner, you will receive compensation for adding liquidity and benefit from an increase in the value of the coins you are adding liquidity to. Even if you would suffer a temporary loss, you would prefer to do it while your overall value is increasing rather than decreasing.

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Disclaimer
The information contained in this article is for informational purposes only and does not constitute financial, investment, or other professional advice. The views expressed in this article are those of the author and do not necessarily represent the views of the company or organization they work for or Pando. Any investment decisions made by the reader should be made after consulting with their own financial advisor and conducting their own research. The author and the company or organization they work for and Pando will not be liable for any financial losses incurred as a result of reliance on the information contained in this article.