You should know what impermanent loss means if you are into decentralized finance (DeFI) and especially liquidity mining. As my learning bit of the day, I try to explain.
When you provide liquidity to a decentralized exchange's (DEX) liquidity pool like Uniswap, you usually offer two different coins to a pool. The provided liquidity can then be traded on the exchange.
Impermanent loss refers to a deprivation that happens when the price of the deposited assets changes between deposit and withdrawal. The loss is realized when withdrawn. The best is to provide liquidity for crypto assets with similar price movements; the impermanent loss is the biggest if one coin loses a lot and the other wins a lot. If the price of both cryptocurrencies is declining at a similar percentage, the impermanent loss is also small.
Here are some examples
Before you start with providing liquidity, you should understand the projects you are investing in, how Automated market makers (AMM) work, dive into the technicals like use cases, price history, total value locked (TVL), and annual percentage yield (APY). It would help if you also understood Impermanent Loss, different scenarios, and the risk-reward ratio.
To illustrate impermanent loss, we will show some examples. We will use the Impermanent Loss Calculator to show some scenarios. We are not considering the APY in our examples.
Let's say you were providing Axie Infinity (AXS) and Wrapped Ethereum (WETH) to farm the Ronin (RON) Token prelaunch. Here are some scenarios.
Example 1: Both assets prices increased
Prices 1. Feb 2022
1 AXS $50
1 ETH $3000
Prices 7. Feb 2022
1 AXS $70
1 ETH $3100
Impermanent loss: 1.14%
If $500 of AXS and $500 of ETH were held
- Have 10.00 AXS and 0.17 ETH
Value if held without providing liquidity: $1,216.67
If $500 of AXS and $500 of AXS were provided as liquidity
- Have 8.59 AXS and 0.19 AXS (in liquidity pool)
Value if providing liquidity: $1,202.77
You gained over $200 in both cases, but as a liquidity provider, your total value is $14 less than when you just would hold your coins. The reason for that is impermanent loss.
Example 2: Both assets prices decreased
Prices 1. Dec 2021
1 AXS $135
1 ETH $4300
Prices 7. Feb 2022
1 AXS $70
1 ETH $3100
Impermanent loss: 1.34%
If $500 of AXS and $500 of ETH were held
- Have 3.7 AXS and 0.12 ETH
Value if held without providing liquidity: $619,72
If $500 of AXS and $500 of AXS were provided as liquidity
- Have 4,37 AXS and 0.1 ETH (in liquidity pool)
Value if providing liquidity: $611,40
In both cases, you lost around $400. As a liquidity provider, your total value is $8 less than when you just would hold your coins. This is because of impermanent loss.
Example 3: One asset's price increases and one decreases (most significant impermanent loss)
Prices 1. Dec 2021
1 AXS $70
1 ETH $4300
Prices 7. Feb 2022
1 AXS $140
1 ETH $2150
Impermanent loss: 20%
If $500 of AXS and $500 of ETH were held
- Have 7.14 AXS and 0.12 ETH
Value if held without providing liquidity: $1250
If $500 of AXS and $500 of AXS were provided as liquidity
- Have 3,57 AXS and 0.23 ETH (in liquidity pool)
Value if providing liquidity: $1000
The impermanent loss is 20%, and if you just would hold both tokens, you would have made $250 more.
If the price of your provided assets moves in different directions, it's the worst-case scenario when it comes to providing liquidity. In the example, it looks like you always lose when you provide liquidity compared to just holding the coins. This is not true and is just the case because we did not consider APY and other rewards.
You can also provide liquidity in the form of stable coin pairs. In a bull market, this does not make much sense since you are not profiting from the rise in the market. In the bear market, this can make sense since you are earning a share of the trading fees by providing liquidity.
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