What is an impermanent loss?
š¬šProviding liquidity to a pool of funds is a common way for users to increase their returns. However, while pursuing gains, we also need to pay attention to the important concept of impermanent losses. This article will cover some strategies to help you reduce or avoid impermanent losses in the process of providing liquidity.
The so-called ā Impermanent lossā refers to the price difference between the tokens held in the liquidity pool of participating market makers and the tokens held in the investorās wallet, that is, the greater the change in the price of the asset held compared to before providing liquidity, the higher the proportion of impermanent losses suffered. In other words, when you prepare to remove liquidity, the value of your assets may be lower than the value of the tokens you hold, denominated in US dollars.
However, if the price range of the assets in the pool is relatively small, then the risk of suffering impermanent losses will be reduced. For example, the trading price of stablecoins is usually within a relatively stable range. In this case, the liquidity provider (LP) will face less risk of impermanent losses. Therefore, when considering the provision of liquidity, we need to carefully consider the impact of impermanent losses on the capital pool, so as not to cause unnecessary losses.
How does impermanent loss happen?
š®Letās go through an example of how impermanent loss may look like for a liquidity provider. Suppose I have 500 USDT and 2500 MEER in my hand. Based on the market price, 1 MEER is equal to 0.2 USDT. Now I have two choices.
Option 1: Provide liquidity
Provide 500 USDT + 2500 MEER in a coin pair to the liquidity pool
When the price changes: 1MEER = 0.4USDT (price on external exchange)
In this case, arbitrageurs can buy MEER in CandySwap at a lower price than the market price and sell it at a higher price on other exchanges, which will lead to a decrease in the number of MEERs in the liquidity pool and an increase in the price of MEER. Until 1 MEER equals 0.4 USDT (arbitrage opportunities disappear).
At this point, after removing the LP Token, I get 1,767.77 MEER + 707.11 USDT, which is equivalent to holding 1,414.21 USDT.
Option 2: Hold assets without any operation
When the price changes, assuming that 1 MEER equals 0.4 USDT, then an asset of 500 USDT and 2,500 MEER will be equivalent to holding 1,500 USDT.
Under the same conditions, if you choose to provide liquidity (Option 1), compared with holding assets (option 2), the return on assets will be reduced by 85.79 USDT, which is equivalent to a decrease of 5.72%. This part of the Loss is called āImpermanent Lossā, because, when the price of MEER recovers to 0.2 USDT, the impermanent losses will disappear.
Impermanent loss estimation
š§®So, impermanent losses happens when the price of the assets in the pool changes. But how much is it exactly? We can plot this on a graph. Note that it doesnāt account for fees earned for providing liquidity.
The horizontal axis of the chart shows the range of changes in asset prices, and the vertical axis shows the proportion of impermanent losses.
By looking at the proportion of impermanent losses corresponding to asset price changes, we can more intuitively understand the scale of impermanent losses.
Hereās a summary of what the graph is telling us about losses compared to HODLing:
If you are interested in the calculation of impermanent losses, consider using the tool dailydef.org to better understand the possible impact of impermanent losses on your portfolio.
Strategies for mitigating impermanent loss
ššNow, everyone should understand what is an impermanent loss. So how do we deal with the occurrence of impermanent losses? Although it is an inevitable phenomenon that price fluctuations will cause impermanent losses in the liquidity pool, we can still reduce the impact of impermanent losses by adopting some strategies. Here are some basic strategies for mitigating impermanent losses for your reference:
Donāt choose high volatility liquidity pools
- Choose a liquidity pool with lower volatility and greater depth:
This can reduce the impact of price fluctuations on liquidity providers. By choosing such a liquidity pool, you can better protect the value of your assets.
- Choose a liquidity pool that uses stablecoins as trading pairs:
Such as the MEER/USDT liquidity pool, whose value has nothing to do with the fluctuations in the value of the governance token. This will reduce the risk of impermanent losses.
- Donāt choose high volatility liquidity pools:
Highly volatile liquidity pools may lead to greater impermanent losses, and it is best to avoid providing liquidity to such liquidity pools.
It should be noted that some of the governance tokens issued by unofficial eco-projects are not directly linked to the value of stablecoins, so their value often fluctuates depending on market demand. At the same time, it is important to note that liquidity pools centered on a single volatile asset, such as liquid pools dual Tokens, are a major source of impermanent loss risk. Such pools of capital fluctuate more in intraday prices, so from the perspective of impermanent losses, the greater the volatility, the greater the impermanent losses.
Participate in the liquidity mining program
The liquidity mining plan is an activity mechanism that encourages liquidity providers (LPs) to increase liquidity by rewarding them with governance tokens. Participants receive transaction fees and token rewards by participating in liquidity mining, which can usually compensate for losses caused by impermanent losses.
In fact, during the period of participating in liquidity mining, if the token reward you receive is equivalent to 25% to 100% of the initial liquidity value you provided, then the 5% unpredictable loss suffered in the process of providing liquidity is relatively insignificant. Therefore, as an LP, it is best to choose liquidity pools that provide incentives. In this way, you can not only earn transaction fees, but also compensate for possible impermanent losses through activity rewards.
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ššOverall, avoiding impermanent losses requires careful selection of a suitable liquidity pool, considering factors such as volatility, depth, and stability of trading pairs. These suggestions can help you reduce the risk of impermanent losses.
