Understanding Impermanent Loss in Crypto and How to Reduce It

Good morning all!

It appears that every time someone talks about a liquidity pool in these forums somebody always chirps up and asks what impermanent loss is.

There’s a million guides but they can be very complicated to understand. I intend here to put it as simply as possible so that all newcomers can try to wrap their heads around it. I’m going to use friendly apples and oranges for my analogies 😊

And just so we’re all clear on the acronyms I’ll be using.

DEX = Decentralised Exchange LP = Liquidity Pool IL = Impermenant Loss APR = Annual Percentage Rate

Let’s break it down!

— What is a liquidity pool? -

A liquidity pool is some where you ‘pool’ two tokens together and provide them as a sort of funding to help other users perform trades or swaps. Think about it. If someone has an apple and they want to swap it for an orange at the shop the shop keeper (DEX) needs to have oranges in stock to do so. Who provides the shop keeper the oranges? The liquidity pool provider does, AKA you!

— But why would we provide the shopkeeper with oranges or apples? -

The shop keeper (DEX) needs apples and oranges to perform these trades so in return for you lending them your assets you will be rewarded. Usually either more apples or oranges. Some shop keepers (DEX’s) will issue extra rewards on top. Maybe in the form of their own native currency, alongside the apples or oranges.

How many apples and oranges to I have to lend? -

As many or as little as you like! But there are two things to consider. * The more you lend, the bigger your reward will be! If you lend so much that out of all the shops apples and oranges 50% belong to you, you will receive 50% of the shops total rewards. NEAT! * You have to lend the shop an equal value of oranges and apples. So if an apple is $1 and an orange is 10c. You will have to lend 10 oranges for every 1 apple. EASY!

— How much rewards will you get? -

Each shop (DEX) have varying rewards for different types of apples or oranges. The shop usually only has a set number of apples or oranges they can use for rewards per year and so the more people lending their assets, the less rewards there are to share between all the lenders per year. This is known as APR. Some APRs are very high 100% plus, some are low at around 10%. Usually the APR can tell you two things. How many apples or oranges the shop has per year for their rewards or how many/ few lenders there are in the LP.

Can I take my apples and oranges out whenever I want? -

Usually YES! As a liquidity pool provider you can usually take your apples and oranges out from the shop whenever you like. But be careful of something called impermenant loss! (IL)

— What is impermenant loss? -

Let’s say you have 100 apples and 100 oranges, each fruit is worth 50c. You lend them to the shop to start earning more apples as a reward, a total of $100 has been put into the liquidity pool.

Now let’s say that apples go up to $1 each and oranges are still 50c. You’ve got $150 in the LP right? Wrong!

You see the shop has to have 50% apples and 50% oranges, in value, so that it has enough of each to swap whenever someone wants to buy or swap them.

This means that now you have less apples and more oranges in your LP. Something like 150 oranges and 50 apples. In this case, you may now have a total of $125 in you LP position (150x50c + 50x$1).

This is less than if you had just kept your apples and oranges at home because you would have 100 oranges ($50) and 100 apples ($100). $150 total.

So you now have a $25 impermenant loss.

— Why is it called impermenant? -

Because you haven’t really lost the money. PHEW! Not yet… If you then decide to take your apples and oranges out of the shop you will only get 150 oranges and 50 apples. At this moment your IL becomes a realised loss because you have $25 less apples and oranges than if you’d just held onto them.

— Why would anyone do this then? -

Well! Let’s imagine two things. Firstly:

Your apples and oranges have been at the shop for 1 year and the APR was 100%, your reward is oranges… You have earned an extra 100 oranges for lending your assets to the shop. So you now have 250 oranges at 50c each and 50 apples at $1 each. That’s a total of $175! So your impermenant loss has been offset by your rewards. It’s worth noting that this isn’t always the case, depending on your shops APR and time you’ve been a LP provider, your oranges may only be worth a fraction of this… Crypto is volatile and prices can go anywhere!

Secondly: If the apples and oranges stay at 50c each or even go the $1 each, you will still have the same amount of apples or oranges in the LP as when you started.

— So if the prices change of assets that’s when impermenant loss can happen? -

YES! When either price goes up or down a balance of value must exist in the LP. So to keep the balance the amount of apples or oranges has to change.

— So…

Liquidity pools can exist outside of DEX’s but this is where they are largely found. There’s all different kinds for different types of apples and oranges, different rewards rates, different risks and different platforms. It’s important to understand what you’re getting involved in before joining but they are an important sector for crypto and the world of decentralised finance!

As ever be careful, do your homework and enjoy your apples and oranges! 😊

PS. This is a very loose guide, I’d advise doing heavy external research before jumping in!

Is there a % in growth that it’s a good idea to pull funds from an LP to avoid losing more if that coin continues to pump? I’m new to defi LPs and curious about people’s strategies.

Honest, I have read a bunch about impermanent loss and still only understand the basics.

Hey everyone. I wanted to briefly explain why impermanent loss, relating to specifically liquidity pools isn’t always such a bad thing.

Impermanent loss occurs when a token that is provided to a liquidity pool incurs a loss of value over simply holding the coin due to liquidity pool coin balancing. I won’t cover that mechanic because it’s been done a thousand times over but do check my posts for a dummies guide on that…

So let’s say you add $1k moons and $1k ETh to a liquidity pool. And you stake in there for a year.

Oh no! Moons does a 50x! Whatever will we do?!?!?

Well the thing is, you haven’t lost any money. Sure you’ve lost what you COULD have had but there’s a million scenarios in which you could have made more profit in every trade. Let’s look at what has happened and why it’s not a bad thing. (Always).

Firstly, you’ve got a shit load more ETH. As your moons go up in value the liquidity pool trade then for ETH to balance to pool. So incrementally you get more and more value in ETH. Not as much as if you held Moons but still a tidy profit. (Arguably in a very nice coin too).

Secondly, you’ve been in this pool for a year. You still have a bounty of Moons as your reward yield to trade. Maybe even double what your originally put in. Relax, think, invest again or sell. Super!

Thirdly, you could have done a million other things with your money. You could have bought a new car or a takeaway, put it into savings, lost it at Roulette! The point is, you’ve won. You’ve done better than the 99.9% of other scenarios. It’s like trying to sell at the top, it’s impossible.

Profit is profit, so don’t shy away because “you could do better”. If you think it’s going to yield you a good return, you’ve done your homework and have weighed the risks then don’t let impermanent loss put you off. It’s a buzz word that gets stigmatised against liquidity pools without any real thought process. Think for yourself and do what YOU think is right.

If you need any extra help with this topic feel free to ask! 😊

We're reaching new levels of copium in here.

Your investment being down 50x is very much a bad thing every time lol

I think people see the word 'loss' and assume the worst. Really impermanent loss is best seen as an opportunity cost.

I'm new to Liquidity Mining and I'm hearing this term over and over again. I still don't fully understand it; what is impermanent loss?

In essence: If you provide liquidity to a liquidity pool (e.g. 50% ETH and 50% ADA) and one of the two assets (e.g. ADA) loses value (compared to the other) you will most likely have more of the worse performing asset in the pool (e.g. 30% ETH and 70% ADA)When you would have made more money just hodling them, you suffered from impermanent loss.

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I think this is the best article on how to avoid it:

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Long story short: use pairs which values are coupled to each other (e.g. two stable coins)

I remember someone here that made $408 by providing liquidity to the moon LP instead of $420 if he had just hold the Moons and Ethereum but dew to also getting rewards in actuality he made $417 if I recall correctly. So in even if you lost some money because of impermanent loss it could be negligible.

Also as a reminder impermanent loss is called impermanent because the token that 50x could very well do a 1/50x dump basically negating the loss. Impermanent loss becomes permanent only when you unstake your position.

So I have been researching looking at youtube videos . Specifically whiteboard crypto i honestly think he gives the best learning tools. But i cannot grasp the idea of IL please help 🤝

When you supply a liquidity pool, you usually supply 50% of one asset and 50% of another in USD value (Curve and a couple other protocols are exceptions).

Let's say you supply the following to a pool:

• $1000 of USDC (1000 USDC)
• $1000 of ETH when it's valued at $3000/ETH (so .333334 Eth)

Let's say the very next day, ETH balloons to $6000/ETH

So now the value of what you put in is $3000. However, because it was in a liquidity pool, during the price change of ETH, the pool will automatically rebalance your token to give you EQUAL USD amounts of ETH and USDC

So you're not going to have an LP token worth $3000, because as the price of ETH went up, the LP token rebalanced all the way up. Essentially, every time the price of ETH goes up, the LP token takes a part of your ETH and gives you its value in USDC. It's kind of like reverse compound interest. Every time it rebalances you've got less ETH in the pool and are getting less benefit from ETH's price movement.

So the impermanent loss is the difference between the value you WOULD have had if you'd just kept the ETH instead of pooling it, and the current value of the LP token.

However, none of this takes into account the Pool and staking rewards you're presumably getting over time. If your staking and pool rewards are enough over time then impermanent loss is irrelevant.

The Calculator Guy has a great IL calculator he explains in this video:

Link to the calculator is in the description.

If you use the calculator with my examples, you'll see that after 1 day and a price balloon to $6000 for ETH, you'll have the following in the LP token:

• USDC: 1414.214977
• ETH: 0.2357024961
• Total Value: $2,828.43

So your impermanent loss is -$171.57

Tania 16 June, 2021

In this article, I will briefly explain what Impermanent Loss means and how this phenomenon can affect the profit of liquidity providers.

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This concept reflects the temporary loss of a part of the liquidity owned.

The phenomenon occurs within liquidity pools, where the liquidity provider must include proportional amounts of 2 different tokens.

If one of the tokens is more requested, then the proportion of the two assets in the pool changes.

In case the provider now decides to withdraw their assets from the liquidity pool, they risk not recovering the entire amount and in the proportion in which they have deposited it.

To support the funds of an AMM, person X deposits 1 ETH and 100 DAI in a liquidity pool at a 50/50 ratio.

The amounts of the deposited tokens must have an equivalent value.

In the case described, this means that the price of 1 ETH is 100 DAI at deposit time. 

Also, let’s say that the current dollar value of person X’s deposit is $200.

If the total in that pool (also supported by other providers) is 10 ETH and 1,000 DAI, person X holds a 10% share of the fund, and the total liquidity is 10,000.

In this case, let’s suppose that the ETH price increases to 400 DAI.

If this happens, arbitrage trading strategies will add DAI to the pool and remove ETH until the ratio reflects the current price.

Since AMMs don’t work with order books, the price of the assets is given by their ratio in the pool.

In short, if the liquidity remains constant in the fund (10,000), the ratio of the assets in it changes.

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If ETH has come to be 400 DAI, the ratio of the existing ETH and DAI amounts in the pool has changed. 

There are now 5 ETH and 2,000 DAI in common, but if person X decides to withdraw their funds, they are entitled to 10% of that pool.

So, they can only withdraw 0.5 ETH and 200 DAI, totaling $400.

Although profits of $200 resulted, the amount would have been different if they had continued to hold 1 ETH and 100 DAI.

The combined dollar value of these assets would now have been $500.

The loss was not substantial, as the original deposit was a relatively small amount.

In other circumstances, the impermanent loss may result in the loss of a significant part of the original deposit.

Our example completely ignores the trading fees that the provider would have earned.

In many cases, the earned fees can cancel losses and make supplying liquidity profitable.

It is crucial to understand the concept before providing liquidity to a DeFi protocol.

I liked this explanation from binance academy:

Let's suppose that the two digital assets in the liquidity pool are ETH and DAI, and you deposit 1 ETH and 100 DAI.

This type of AMM (automated market maker) requires that the two deposited assets maintain a 1:1 ratio, which means that 1 ETH = 100 DAI.

Since 1 DAI = 1USD, your deposited assets are now valued at $200.

Now imagine that the total pool contains 10 ETH and 1,000 DAI, which is worth $2,000. This means you have a 10% share of the pool. The constant is k = 10 (ETH) * 1000 (DAI) = 10,000, which must always be equal before and after a transaction in the pool.

Suppose that the ETH price rises to 400 DAI. According to the AMM formula, the price of ETH in the pool is still 100 DAI. At this time, arbitrageurs can buy ETH at a lower price from the liquidity pool until the token price is back in line with the external price.

If we ignore the transaction fees, there will be 5 ETH and 2,000 DAI in the liquidity pool. At the same time, the constant k is still 10,000. If you decide to withdraw funds during this time, you can now withdraw 0.5 ETH and 200 DAI (10% of the pool), which equals $400 (excluding fees).

That doesn't seem so bad, but wait! If you would have HODLed rather than deposited these tokens, you would now have $500 worth of assets. So that's how you can lose $100 compared to just holding your tokens, and this is what we call impermanent loss.

Source:

This IL calculator was the only thing that helped me to understand it tbh. It allows you to enter the starting price of your assets, and a closing price. Then highlights the return you would get from just holding the asset, vs. return from providing liquidity for that pair.

I'd recommend playing around with some figures to get your head around it. And then hopefully come to the conclusion that you should avoid LPing for non-stablecoin pairs like the absolute plague.

You buy Rook at $700 while Eth is around $1k. Eth 4x's while rook plummets and now you've got more Rook but you'd have been better just holding Eth and not LPing.

Hi,

I'm pretty new to crypto, and trading as well. Been about two months and it's been an excellent ride so far learning about PoS, DeFi, Layer 2's etc. This is all just really exciting technology.

Upon my readings into DeFi, which of course includes providing liquidity and staking in liquidity pools. Seems to make sense. But, for the life of me I can't quite fully comprehend the whole picture of impermanent loss. Sure, plenty of write ups will definitely include this as a massive risk in providing liquidity - making it sound like you could loose everything because of it.

As far as I currently understand it, you could suffer some impermanent loss should the value of the coin pair you're providing for liquidity goes up. I think I have grasped this - you get rewards from providing the liquidity but they don't compare if those coins start mooning and increasing in value faster than you're getting liquidity rewards. But is this really a loss? To me this is just bit more like a bad decision or bad luck - okay, you made some money but you could've made more.

But what happens if the value of those coins drops significantly? I've yet to find anything that explains this scenario?

I guess another question, that relates to this is - when you take you're tokens out of providing liquidity, you get the same amount back? Does the amount of the coins change, even though the value of those coins may have changed?

So, if the market goes up = well, bad luck, you could've made better gains just holding. If the market goes down = well, bad luck, but the coins have lost value regardless of holding them or not. Is it the best bet to try to stick to just stable coins for providing liquidity?

Thanks for reading through all this. I just wasn't finding any helpful articles about this in particular - I just kept finding the same type of clickbait "DeFi made me a millionaire shocked faced" sort of articles.

IL measures equity loss resulting from asset rebalancing in an automated market maker. Since LPing is effectively a dollar cost accumulation strategy, it is the difference of profit one would have comparing buying the bottom and selling the top versus holding the two assets in an LP over an arbitrary timeframe.

In other words, liquidity providers are the house and traders are the gamblers. In a small amount of instances over small time frames, gamblers win. The whole concept of IL is looking at the few gamblers who win and saying 'if I had gambled I'd have slightly more profit over this time interval.'

IL is difficult to wrap your mind around because it's a nonsense concept.

Question about providing liquidity to a pool and calculating impermanent loss.

I know how the concept works, and that as the tokens drift apart in value arbitragers will buy / sell from the pool to maintain the proper ratio between tokens.

I get how that can lead to impermanent loss when you sell.

The part I’m not sure about is what happens if the token values basically just oscillate? One goes up vs the other, then the other goes up, and vice versa.

Let’s say they do this a fair bit and in the end basically end up where they started. Is there no impermanent loss because their relationship between each other stayed in general the same, or did all the movement and arbitraging to update the price cause impermanent loss each time?

No.

Liquidity pools maintain a 50:50 ratio in value. If you put in 100 coin A and 100 coin B. Then coin A increases in value and coin B stays the same. You now have more (in fiat terms) of coin A than coin B so you'll automatically sell some of coin A to buy coin B to maintain that 50:50 ratio.

This means that if 1 coin is increasing in value you are constantly selling it to buy the other coin and therefore your coins would have had more value if you'd just kept 100 coin A and 100 coin B. You didn't actually lose anything you just didn't make as much as you could have. However the fees from the pool will hopefully be more than enough to cover the difference (if the 2 coins only change relative to each other a small amount).

If the coins only increase in valve then your share of the pool will increase in value, but maybe not as much as if you'd just held the coins.

This of it as an average (this example is a little off, but it should make sense).

Let’s say you want to provide BTC/ETH liquidity. You put $100 of each in. Your LP will be worth the average of BTC and ETH.