Crypto trading has grown in popularity as a means for investors to profit from the digital asset market. Yet, with this new investing choice comes more risks, such as the potential of impermanent loss. Impermanent loss is a typical occurrence in decentralized finance (DeFi) trade, but what precisely is it? In this article, we will look at impermanent loss, its causes, and how it impacts crypto traders and investors.
Understanding Impermanent Loss
Impermanent loss occurs when you provide liquidity to a liquidity pool and the price of your deposited assets varies from when you placed them. The greater the magnitude of the change, the more vulnerable you are to impermanent loss. In this situation, the loss equates to less monetary value at the time of withdrawal than at the time of deposit.
When you deposit tokens into a liquidity pool, you’re effectively speculating on the price ratio between the two tokens being reasonably consistent. You may incur an impermanent loss if the price ratio of the two tokens changes.
The loss is dubbed “impermanent” because it occurs only when you withdraw your tokens from the liquidity pool. If the price ratio between the two tokens recovers to its previous level, the loss is considered “permanent.”
Why Does Impermanent Loss Happen?
Impermanent loss takes place due to the way liquidity pools operate. When you deposit tokens into a liquidity pool, you are actually selling those tokens to other traders who wish to trade them. The liquidity pool’s algorithm determines the price of the tokens in the pool, which takes into consideration the ratio of the two tokens in the pool.
Whenever the price of one of the liquidity pool’s tokens changes, traders will begin buying or selling that token in order to balance out the pool’s ratio. This will cause the token’s price to deviate from the initial ratio, resulting in an impermanent loss.
Example of How Impermanent Loss Works
Assume you put 1 ETH and 1000 USDT into a liquidity pool and get 1000 LP tokens in exchange. The pool’s ETH to USDT ratio is 1:1000.
Let’s imagine the price of ETH rises by 10%. Traders will begin purchasing ETH from the pool in order to balance the ratio, leading the price of ETH to rise even further. As a consequence of this, the pool’s ETH/USDT ratio will change to 1.1:1000.
You will receive 1.1 ETH and 1000 USDT if you withdraw immediately. However, if you had just kept your initial 1 ETH and 1000 USDT, you would now have 1.1 ETH and 1100 USDT. This indicates you’ve suffered an impermanent loss of 100 USDT.
How to Minimise Impermanent Loss?
Impermanent loss can be minimised by understanding how it functions and taking precautions to reduce your risk. Here are several methods you can use to mitigate impermanent loss:
- Managing the Size of Your Position
Limiting the size of your position in the liquidity pool is one strategy to prevent temporary loss. You may lessen the effect of price changes on your portfolio by keeping your position small.
- Selecting Stablecoin Pairs Carefully
To reduce the chances of suffering impermanent loss, select stablecoin pairings such as USDT/USDC or DAI/USDC. These cryptocurrency pairs are less volatile than others and are more unlikely to see substantial price movements.
- Employing a Hedging Approach
A hedging strategy can be used to reduce temporary loss. One method is to sell the assets in the pool short. If the price of the asset declines, you will profit on your short position, which will make up for the loss in the liquidity pool.
Should I Still Provide Liquidity to a Particular Pool?
It’s vital to acknowledge that supplying liquidity to a decentralized market carries the risk of impermanent loss. While it can be reduced to some degree, it cannot be eliminated entirely. As a result, it’s critical to assess the possible advantages against the dangers before deciding whether to provide liquidity to a certain pool.
Even if you’re already doing so, keep an eye out for news and developments on the tokens in the liquidity pool for which you’re providing liquidity, as well as any shifts in broader market conditions. This enables you to make an educated judgment on when to deposit and withdraw tokens from the pool.
Ultimately, impermanent loss is an indispensable concept for crypto traders to be aware of, especially those who are providing liquidity to decentralized exchanges. Traders can reduce their risk of impermanent loss through the use of various strategies such as adhering to low-volatility trading pairings, using impermanent loss calculators, diversifying liquidity sources, and paying attention to market conditions. However, it is critical to remain informed and updated in order to balance the potential benefits and possible risks.
Disclaimer: This material is for information purposes only and does not constitute financial advice. Flipster makes no recommendations or guarantees in respect of any digital asset, product, or service. Trading digital assets and digital asset derivatives comes with significant risk of loss due to its high price volatility, and is not suitable for all investors.