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Impermanent loss - what is it and how to avoid it?

What do we call an impermanent loss?

There is always a possibility of impermanent loss, sometimes. The difference in the value of two tokens in a liquidity pool is what we call an impermanent loss.

For example, yield farming, in which investors lend their tokens to gain rewards, is related to impermanent loss. We must say that it is different from staking, where investors must inject money into the blockchain to validate their transactions.

Yield farming, on the other hand, requires investors to lend their tokens to a liquidity pool or to provide liquidity. The rewards are different, depending on the protocol. 

Yield farming is a profitable strategy, yet it has its risks, some of which are liquidations, control and price risks. 

It is the number of liquidity providers and tokens in the liquidity pool, which defines the risk level of impermanent loss. The token is being coupled with a stablecoin, as pools with stablecoins are less vulnerable to temporary losses. The result is a lower risk of impermanent loss.

Impermanent loss protection

This is a type of insurance, protecting liquidity providers from losses. 

As liquidity provides profit only on automated market makers, when the benefits of farming are more than the temporary loss. Of course, when the liquidity providers suffer losses, they can utilize Impermanent loss protection against impermanent loss. To activate the protection, tokens must be staked on a farm. So, when a user makes a deposit, the insurance coverage grows at a given rate per day, and eventually reaches full range.

If a temporary loss happens, it is covered at the time of withdrawal by the protocol. Compensations are different, depending on the time of withdrawing. 

Impermanent loss example

Let’s see an example of an impermanent loss with the most famous cryptocurrency - Bitcoin, in a bull market scenario.

Let’s say a liquidity provider uses 10 Bitcoin in a liquidity pool, containing 50% Bitcoin and 50% USDT. 

So, if the price of Bitcoin in that given case is $20,000, we will have 10 BTC to contribute, and 200,000 USDT.

If the liquidity pool has a total asset value of 50 Bitcoin and a million USDT, we can say that the liquidity provider holds a 20% share in the pool.

If the price of Bitcoin doubles, the liquidity provider will have 10 BTC and 400,000 USDT. The value of the liquidity pool would also double. 

So, if the provider decides to withdraw the assets, he would get 20% of the BTC liquidity or about 7 BTC. If he chooses to keep the assets in a separate wallet, the provider will end up with 10 BTC times 40,000 USDT and 400,000 USDT, or 800,000 USDT.

The impermanent loss would be in the difference between 800,000 USDT and 282,842 USDT.

As a conclusion to the example, the larger the change in a token price, the bigger the impermanent loss will be.

Can we avoid impermanent loss?

To be honest, the risk can never be entirely avoided. Of course, there is a possibility of mitigating the chance of impermanent loss.

One of the ways to avoid losses is to choose stablecoin pairs, offering the best bet against impermanent loss. The fewer arbitrage opportunities they provide, also lowers the risk.

Anyway, you can look at impermanent loss as a loss before you actually make money.

Technically, the loss is temporary, as the value of cryptocurrencies may always move back to their initial level. So, the loss is permanent only if the investor withdraws money from the liquidity pool.

It is important to say that there is also a possibility that the token price never regains its former value, which sometimes makes the insignificant loss irreversible

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