Impermanent Loss is a critical term in the field of DeFi, especially when participating in Liquidity Pool markets. Understanding this concept thoroughly will help you make informed investment decisions and avoid potential risks. 

Follow this article to explore everything you need to know about Impermanent Loss, from its definition and mechanics to calculation methods and risk mitigation strategies.

What is Impermanent Loss?

Impermanent Loss is a temporary loss that liquidity providers (LPs) may experience when participating in providing liquidity on automated trading platforms (AMMs) such as Uniswap, PancakeSwap, SushiSwap. 

This loss occurs when the prices of the two tokens in the liquidity pair fluctuate relative to each other, resulting in a divergence in the value of the liquidity pair compared to simply holding those tokens without providing liquidity.

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How Impermanent Loss work

To better understand Impermanent Loss, let's consider a simple example: Suppose you provide 1 ETH and 100 USDT into an ETH-USDT liquidity pool. At the time of providing liquidity, the price of ETH is 1,000 USDT. You receive LP (Liquidity Provider) tokens corresponding to the amount of ETH and USDT you provided to the pool.

Case 1: ETH price increases to 2,000 USDT

In this scenario, the value of ETH you hold in your wallet doubles, from 1,000 USDT to 2,000 USDT. However, because you provided 1 ETH and 100 USDT into the pool, the ratio between ETH and USDT in the pool will change, potentially decreasing the value of the LP tokens you receive. This is called impermanent loss because if you held ETH in your wallet, its value would have doubled to 2,000 USDT, but by providing liquidity to the pool, the value of LP tokens only increases according to the new ratio between ETH and USDT.

Case 2: ETH price decreases to 500 USDT

In this scenario, the value of ETH you hold in your wallet halves, from 1,000 USDT to 500 USDT. However, because you provided 1 ETH and 100 USDT into the pool, the ratio between ETH and USDT in the pool will adjust to reflect the current market price. This adjustment may decrease the value of the LP tokens you receive. If you held 1 ETH in your wallet, its value would still decrease to 500 USDT, but by providing liquidity to the pool, the value of LP tokens decreases according to the new ratio between ETH and USDT.

From these examples, we can see that Impermanent Loss is not an absolute risk but simply a difference in value between providing liquidity to a pool and holding assets in a wallet. However, when the value of assets in the pool changes rapidly or experiences significant volatility, Impermanent Loss can lead to substantial losses.

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To calculate Impermanent Loss, you need to know the current value of your initial deposit and the current value of the asset ratio you provided in the pool. According to the following formula:

Impermanent Loss = Current value of initial deposit − Current value of asset ratio you provided in the pool

For example: In Case 1, the current value of the initial deposit is 2,000 USDT (2 ETH x 1,000 USDT), and the current value of the asset ratio you provided in the pool is 3,000 USDT (1 ETH x 2,000 USDT + 100 USDT). Therefore, your Impermanent Loss would be 2,000 USDT - 3,000 USDT = -1,000 USDT.

Factors influencing Impermanent Loss

There are several factors that can affect the extent of Impermanent Loss you may incur when providing liquidity to a pool. These factors include:

Asset price volatility

The most important factor to consider is that Impermanent Loss occurs only when the prices of assets in the pool change compared to the initial values you provided. Therefore, the degree of asset price volatility significantly impacts Impermanent Loss. Lower volatility in asset prices results in lower Impermanent Loss.

Asset supply ratio

The ratio of assets you provide to the pool can also affect Impermanent Loss. If this ratio is uneven and there is a large discrepancy between the assets, Impermanent Loss will be higher.

Transaction fees

In DeFi, transactions often incur fees, which are deducted directly from the amount of LP tokens you receive when providing liquidity to the pool. Therefore, higher transaction fees correspondingly increase Impermanent Loss.

How to avoid Impermanent Loss?

Although Impermanent Loss is unavoidable in DeFi, there are several methods to mitigate this risk. These methods include:

Choosing pools with low price volatility

As mentioned, asset price volatility directly affects Impermanent Loss. Therefore, selecting pools with assets that exhibit low price volatility can help minimize this risk. However, this also means that the pool's liquidity might be lower, and withdrawing funds could be more challenging.

Adjusting the asset supply ratio

Adjusting the ratio of assets you provide to the pool can help reduce Impermanent Loss. If an asset's value increases rapidly, increasing the supply ratio in the pool can capitalize on the price rise. Conversely, if an asset's value decreases, reducing the supply ratio and waiting for the price to normalize can mitigate losses.

Researching the project and potential of the pool

Before providing liquidity to a pool, thoroughly research the project and the potential of the pool. If you believe in the project and expect the asset's price to increase in the future, Impermanent Loss may not be a significant concern.

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Summary

Above is an explanation of Impermanent Loss and how to calculate it. To further understand and apply this knowledge, follow the AZcoin cryptocurrency knowledge page for more updates on DeFi-related investment concepts and strategies.