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A Beginner’s Guide to the Impermanent Loss Phenomenon

Decentralized finance, or DeFi, presents several hazards to investors. Impermanent loss is a significant concern when dealing with this growing market.

This guide will explore the meaning of impermanent loss concerning the liquidity pool. Moreover, the guide will also discuss how to calculate the difference and reduce the risk of this phenomenon.

Grasping the Notion of Impermanent Loss

There is a high probability of impermanent loss in every given situation. A net difference in the value of two tokens in a liquidity pool constitutes an impermanent loss.

Imagine a case where:

  • An investor contributes liquidity to a liquidity pool.
  • The relative value of the deposited asset fluctuates during the deposit in relation to its initial value.

In an investing operation, the higher the price change, the greater the potential for a trader to lose. Regardless of the direction of the price, it is essential to remember that impermanent losses might occur.

An example may help you better understand this topic, as we will explain in the dedicated section.

An Easy-to-Read Example of Impermanent Loss

As is often the case, a practical example can help us understand better how a seemingly complex notion works. Impermanent loss can be easy to understand when the price of a token falls. However, the same concept may not be intuitive in a bull market scenario.

For this reason, we will target the most popular cryptocurrency (BTC) and assume a bull market scenario in this example.

Imagine any liquidity provider uses 10 BTC in a liquidity pool. For simplicity, let us assume that the liquidity pool contains 50% BTC and 50% USDT. In this example, to avoid useless overcomplications, we can assume a perfect parity between USDT and the US Dollar. 

If we take $20,000 as the price of one BTC, we have the following situation:

  • Amount of BTC to contribute: 10.
  • Amount of USDT to contribute: 200,000 (i.e., 20,000 times 10).

Let’s assume that this liquidity pool has a total asset value of 50 BTC and 1 million USDT. In other words, we are saying that this liquidity provider holds a 20% share in the pool.

Suppose the price of Bitcoin doubles, hitting $40,000. Intuitively, anyone holding Bitcoin will be happy about this, but what happens in this example?

Here comes the tricky part. The liquidity provider will now have 10 BTC and 400,000 USDT. Note that the value of the pool would also double. Consequently, the liquidity provider would still hold a 20% share of the pool.

Withdrawal & Hodling Options

At this point, we need to compute two important values:

  • BTC liquidity is the square root of the total initial value of the pool funds divided by the BTC price. Consequently, we have 50 BTC multiplied by 1 million USDT, divided by 40,000. The square root of this amount is 35.36.
  • Token liquidity is the square root of the total initial value of the pool funds multiplied by the BTC price. Consequently, we have 50 BTC multiplied by 1 million USDT, multiplied by 40,000. The square root of this amount is 1,414,213.56.

Assume that the liquidity provider chooses to withdraw the assets now. He would get 20% of the available BTC liquidity (i.e., 35.36). We would be talking about 7.07 BTC.

In terms of USDT, the same reasoning would bring us to a withdrawal of 282,842.71 Tether.

What if the liquidity provider chose to simply keep the assets in a separate wallet instead of joining a pool? This calculation is much easier, as the liquidity provider would now have 10 BTC times 40,000 USDT plus 400,000 USDT.

In other words, the liquidity provider would hold 800,000 USDT.

In our example, the impermanent loss is the difference between 800,000 USDT and 282,842.71 USDT. Intuitively, the larger the change in a token price, the more significant the impermanent loss will be.

Are Impermanent Losses Avoidable?

The most honest answer is that liquidity providers cannot entirely avoid this risk. However, it would be wrong to claim that one cannot mitigate the chance of impermanent losses.

Stablecoin pairings that give the most protection against transitory losses are an excellent way to avoid impermanent losses. After our example, the concept is easy to grasp: stablecoins’ prices typically do not move much.

However, a liquidity provider focused on stablecoin pairs can miss significant chances coming from a bull crypto market.

Another critical piece of advice is to keep your eyes on the market. It is relatively easy to automatize the calculation we included in our example. Ideally, a liquidity provider should know at any time how an impermanent loss is evolving on each pool.

“You only lose money when you sell” is a famous mantra in the financial markets. You may think of impermanent loss as a notional loss before you take money from an account.

This loss is technically temporary because cryptocurrency values may always move back to their initial level. In other words, the loss is only permanent if an investor withdraws money from the liquidity pool.

It’s important to remember that a token price may never regain its former value. This aspect makes your seemingly insignificant loss potentially irreversible.

Final Thoughts on the Impermanent Loss Phenomenon

There is no way an investor would ever want to face a loss that is both irreversible and costly. This fallacy is an issue for investors who wish to use the blockchain to take advantage of the crypto market.

Our guide gave the readers a theoretical explanation of what an impermanent loss is. More importantly, we focused on a realistic example in which a liquidity provider may record an impermanent loss.

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Lastly, we shared some common wisdom on reducing the risk of falling into this common DeFi trap.

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