What is Impermanent Loss & How to Avoid It?
The DeFi world is full of lucrative opportunities and along with that, there are some things to be aware of. Many users don’t fully understand the “Impermanent Loss” term and how it can influence their profit. Let’s explore this important topic together and learn how to avoid Impermanent Loss!
What is Impermanent Loss?
Impermanent Loss — is a situation when at the time of withdrawal of crypto from the deposit, the profit from its placement is lower than from simply HODLing the crypto. There is also another definition — Unrealized Profit.
In other words, Impermanent Loss is a reflection of what profit could be if the owner of the tokens used another investing strategy. Impermanent Loss does not become real until the position is closed.
How does Impermanent Loss happen?
Impermanent loss occurs in liquidity pools that consist of at least one volatile token
Let’s explore Impermanent Loss better via this example👇
Suppose that there are two digital assets — BNB and BSW in the liquidity pool. To provide Liquidity to a 50/50 pool, a Liquidity Provider must provide the pool of assets of equal value. For example, 1 BNB = 300 BSW and 1 BSW = $3.
If a user deposits 1 BNB and 100 BSW into the Liquidity Pool and, when the BSW price is $3, the investment is estimated at $1 200 ($900 worth of 1 BNB + $300 worth of 100 BSW).
Now let’s imagine that this is 10% of the total pool since there is a total of 10 BNB and 1000 BSW in the pool. A constant is 10 BNB x 1000 BSW = 10000.
After all transactions in the pool, the constant must remain valid. Even if the value of BNB rises to 600 BSW, in AMM (Automated Market Maker = Liquidity Pool) 1 BNB will always be equal to 100 BSW. They are kind of interchangeable.
As long as the total cost of both tokens is the same, everything is stable. When the value of BNB starts to rise (the token prices in this pool are only affected by the ratio between them and not the prices on external markets), arbitrage traders will intensify their activity (arbitrage — simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price). They buy BNB from the pool at a lower price than the market price is, until it equals the external price. If BNB is now worth 600 BSW, the ratio between how much BNB and how much BSW are in the pool has changed. There are now 5 BNB and 2,000 BSW in the pool. The Constant remains the same 10000.
If an investor who initially invested 1 BNB = 100 BSW decides to withdraw his funds at this moment, he will actually receive 0.5 BNB and 200 BSW (10% of the Pool — remember that BNB and BSW are kinds of interchangeable here), and now his investment will be worth $1 500 ($600=200 BSW + $900=0.5 BNB). Yes, there is lots of profit! But if the investor chose just to hold his crypto assets, their value after the rise of BNB price would be $2 100 ($1 800=1 BNB + $300=100 BSW). This $600 difference is called Impermanent Loss.
Can We Avoid Impermanent Loss?
One of the simplest and most effective ways to avoid Impermanent Loss is to provide liquidity to pairs with low volatility.
Give your preference to esteemed and large projects that have a relatively stable price and are not much vulnerable to volatility. These include cryptocurrencies from the TOP-20 rating in terms of capitalization.
Secondly, choose pairs where the value of one asset regarding another remains fairly stable. For example, it can be paired with stablecoins.
There is a strong argument that earnings would eventually offset price changes. Despite the fact that may be true, the issue is that we cannot cover our losses with our income!
Let’s make a conclusion
Tokens should only be staked after careful consideration, including risk calculations as outlined above. If you start with a large deposit, your impermanent loss will be higher when prices change. Always start small and only invest what you can afford to lose.
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