What is Impermanent Loss in Crypto?
It refers to a situation in which the profit you gain from staking a token in a liquidity pool is less than what you would have earned just holding the asset. It happens when a token’s price changes in the market, which causes your deposited assets in the liquidity pool to become worth less than their present value in the market. The bigger this price change, the more your assets are exposed to impermanent loss.
For example, if the value of the assets in the pool decreases by 10%, but the value of the LP tokens only decreases by 5%, the user will have incurred a 5% impermanent loss.
It indicates how much more the value of your assets would be if you just HODL instead of providing liquidity. This gap is “impermanent” because it is possible to close the gap if the token price returns to the former price. It’s also important to note that impermanent loss does not take into account trading fees that investors earn for providing liquidity, which in many cases can negate any losses.
How Does It Work?
Firstly, it does not necessarily prevent liquidity providers from making a profit. This loss is only tangible if investors withdraw their liquidity from the pool at that exact moment in time. Often, pools employ strategies to offset this loss, such as charging high fees to make more profit. Therefore, liquidity providers make more from fees to cover their impermanent loss.
But, in case of a considerable price difference, your fee profit might not cover the loss. In this case, you would have gained more value if you held the assets instead of providing liquidity.
Let’s see an example:
- Say you deposit ETH worth $500 and BTC worth $500 (total of $1000) at a 10% stake into a $10,000 ETH/BTC liquidity pool.
- Suppose the price of ETH increases to $800 after your deposit; the pool becomes unbalanced and opens up room for arbitrage traders.
- The liquidity pool value increases to $12,000 when it regains balance. If you withdraw your tokens at this point, you get 10% of the pool, which is $1200.
Although it may look like you made more profit, your gains may be less than the base shift in value of your tokens. Due to the price increase, the value of your deposited ETH increased from $500 to $800 while your BTC assets remained at $500. So if you would’ve held your assets, your total profit would’ve been $1300 ($800+$500). You would have made $100 more if you did not participate in the liquidity pool. This is what we call impermanent loss.
How to Calculate Impermanent Loss?
Calculating your exact loss might be a little tricky due to the complexity of some of its variables. But you can estimate your loss with the formula below:
Impermanent Loss = 2 * sqrt(price_ratio) / (1+price_ratio) – 1
The price ratio is the ratio between the token price at deposit and withdrawal.
How To Avoid It?
While you can’t avoid impermanent loss, you can reduce exposure. Here are some tips to help:
- The more volatile the assets, the more impermanent loss is likely to occur. Use more stable tokens like stablecoins or BTC to reduce the chance of impermanent loss.
- Ensure you also use tried and tested Automated Market Makers to reduce your exposure to market manipulation.
- Start by staking a small amount to diversify your portfolio and reduce the percentage of your assets exposed to impermanent loss.