Impermanent Loss Busted! What you need to know
According to a recent study by Topaz, liquidity providers lose $260.1m across 17 pools through impermanent loss. There’s never been a better time to ground yourself with a proper knowledge of impermanent loss than now. Especially if you’re new to DeFi.
Impermanent loss happens when the price of your tokens changes in relation to their original price deposited into the liquidity pool. Well, impermanent loss only occurs when the price of your tokens dips when compared to the original price you deposit to the pool.
Now, let’s simplify it further.
- If the price of one coin goes up and the other goes down, you have IL
- If the price of one coin goes up and the other stays the same, you have IL
- If the price of one coin goes down and the other stays the same, you’ll have IL
To get an optimum reward from providing liquidity, your two coins need to either stay the same or go up. Most times, beginners that are unaware of impermanent loss get rekted and blame the platforms. While in reality, they didn’t DYOR.
How does impermanent loss occur?
For instance, you invested $200 worth of ETH:DAI on SushiSwap , assuming they give 10% APR. At the end of the year, you’re expecting to get 2.2 interest, which is $220. But due to token price changes, you ended up getting $105.
You got lesser than expected, not because the protocol didn’t give you your complete APR. But because the fluctuation in the value of your coins plummeted your interest. That, my fren, is impermanent loss.
How then do you protect yourself?
1. Avoid Volatile Coins
They may be suitable for HOLDing, but not for providing liquidity. As a general rule, the following coins are volatile, and therefore riskier on liquidity pools.
- New coins
- Coins with low liquidity
2. Use Stablecoin Pairs
Stablecoin pairs are the safest to use in providing liquidity. Since they are pegged to the price of $1, they rarely fluctuate. Although most pools give small rewards on stablecoin pairs. But, it helps you optimize for your full rewards.
3. Stick with Pools that offer extra rewards
Most liquidity pools offer incentives to attract and encourage liquidity providers. Try them because your incentive can compensate for any possible impermanent loss while providing liquidity.
4. Provide when a coin price is low
When the value of a coin is low is the best time to use it for liquidity. Not the other way round. What happens is, that you’ll be on the profiting side while it appreciates.
5. Leverage on pools that isn’t 50:50
Using pools that use the 50:50 equation means that impermanent loss will affect your coin pairs equally. Alternatively, with a different matrix-like 60:40, 70:30, or 80:20, there’s a probability that the effect of IL will be milder.
For instance, with Balancer, you can provide liquidity with pairs like 80:20, 60:40, and 33:33:33. Bancor also adjusts weights to different pair types.
Bonus: Tools for calculating impermanent loss
a. Daily DeFi is an online resource covering the DeFi industry. They have a free impermanent loss calculator.
b. Decent Yields is an educational platform aimed at providing insights on DeFi yields and rewards. You can calculate the impermanent loss of your tokens using their free calculator.
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