Impermanent loss is the potential reduction in value of staked assets in a liquidity pool due to market price changes compared to simply holding the assets.
Understanding Impermanent Loss
When you dive into the world of DeFi and liquidity pools, you encounter a term — impermanent loss. This phenomenon occurs when the price of your staked assets in a liquidity pool changes compared to when you deposited them. It’s a risk inherent to liquidity providers.
What is Impermanent Loss in Crypto?
Impermanent loss describes the reduced profit from staking tokens in a liquidity pool versus simply holding the asset. As market prices fluctuate, so does the value of your pool assets. A significant price shift can lead to a loss, albeit an impermanent one, as the name suggests.
- If the asset price in the pool drops by 10% but the LP tokens decrease by only 5%, you face a 5% impermanent loss.
- This loss is ‘impermanent’ because it can reverse if the prices revert to their original state.
- Trading fees earned may offset these losses, but not always.
How Does It Work?
Impermanent loss doesn’t always mean a loss in profit. It becomes real only if you withdraw at the depreciated value. Liquidity pools might charge higher fees to compensate for these losses. However, if the price disparity is large, fee profits may not cover the impermanent loss.
Consider depositing equal values of ETH and BTC into a liquidity pool. If ETH’s price rises significantly, the pool’s value increases, but so does the potential for impermanent loss if you withdraw at this new balance.
How to Calculate Impermanent Loss?
Calculating impermanent loss involves a formula that considers the price ratio of the token at the time of deposit and withdrawal. It’s a bit complex, but here’s a simplified version:
Impermanent Loss = 2 * sqrt(price_ratio) / (1+price_ratio) – 1
How To Avoid It?
While impermanent loss is part of liquidity providing, you can minimize it:
- Choose less volatile assets like stablecoins or BTC.
- Opt for reputable Automated Market Makers.
- Diversify your portfolio to lessen the impact of any single investment.