Impermanent Loss

What Is Impermanent Loss?

Impermanent loss occurs when the current value of assets in a liquidity pool is less than their value at the time of deposit. This means that you — as a liquidity provider — had incurred losses at the current price ratio of the pooled assets, compared to when you deposited tokens to the pool to provide liquidity. The term "impermanent" comes from the fact that these losses are unrealized and only become permanent when assets are withdrawn from the pool. Moreover, the loss will be reversed if the token prices return to their original deposit prices, and the price ratio returns to its initial value.

How to Calculate Impermanent Loss

Calculating impermanent loss involves understanding how price changes affect the value of assets within the pool. For an easy and more precise calculation, you can use the CoinGecko Impermanent Loss Calculator. 

Risks of Impermanent Loss

Impermanent loss is an ever present risk when contributing to liquidity pools, particularly for volatile assets. The degree of impermanent loss often increases with the volatility of the pooled assets. While trading fees or incentives earned from the liquidity pool can offset impermanent loss, they might not always fully compensate for it, especially during extreme price movements.  Liquidity providers should not consider providing liquidity as a form of passive income; rather they should be monitoring and managing their positions actively to avoid losses. 

How to Manage Impermanent Loss

Impermanent loss can't entirely be avoided; however, several strategies can help liquidity providers manage it. Here are some key strategies to consider.

Choose Stable Asset Pairs 

You reduce the risk of impermanent loss by providing liquidity with stablecoins or other low-volatility assets, which are less likely to experience significant price fluctuations. For example, pairing USDC/USDT or DAI/USDC can minimize the risk of loss since these stablecoins are designed to track the value of the US dollar.  One effective strategy for managing impermanent loss, without relying on stable asset pairs, is to use correlated assets for liquidity provision. For instance, pairing stETH/ETH, this way you can enjoy the higher yields of liquidity provision in a volatile asset with lower risks of impermanent loss.

Multiple Asset Pools

Spreading your assets across multiple liquidity pools can help reduce the impact of impermanent losses. By not putting all your funds into a single pool, you curtail the overall risk to your crypto portfolio.

Use Impermanent Loss Protection

Impermanent Loss Protection (ILP) is a feature offered by some decentralized finance (DeFi) platforms to act as insurance against impermanent losses. ILP compensates you if the value of your pooled assets drops below a certain threshold due to price fluctuations. Ultimately, this protection helps mitigate the financial impact of impermanent loss. It is especially useful in volatile markets where the risk of significant price changes is higher.

Monitor Market Conditions 

Stay informed about market trends and the performance of your chosen assets pools. If the market becomes particularly volatile, you can consider temporarily withdrawing your assets to avoid significant impermanent loss.