Impermanent loss

Impermanent Loss: A Beginner's Guide

What is Impermanent Loss?

Impermanent loss is a risk associated with providing liquidity to decentralized exchanges (DEXs) using Automated Market Makers (AMMs). It sounds scary, but it's manageable if you understand what's happening.

Think of it like this: you’re helping a DEX run smoothly by locking up your cryptocurrency to allow others to trade. In return, you earn trading fees. However, if the price of the tokens you’ve provided changes significantly compared to if you’d just *held* those tokens in your wallet, you could end up with less value than you started with. This difference in value is what's called impermanent loss.

The “impermanent” part means the loss isn’t realized until you withdraw your liquidity. If prices revert to what they were when you deposited, the loss disappears. But if prices move further away, the loss becomes permanent.

How Does it Happen?

Let's use a simple example. Suppose you decide to provide liquidity to a trading pair on a DEX, like ETH/BTC.

You deposit 1 ETH and 1 BTC, totaling $2000 (let’s say ETH is $1000 and BTC is $1000).
The AMM creates a liquidity pool combining your tokens with others.
Now, let’s say the price of BTC doubles to $2000, while ETH stays at $1000.
To rebalance the pool and maintain the 1:1 ratio, the AMM will *sell* some of your BTC and *buy* ETH.
When you withdraw your liquidity, you'll receive less BTC than you initially deposited, and more ETH.

Because BTC went up in value outside the pool, you missed out on those gains by having your BTC in the liquidity pool. The difference between the value you’d have if you’d just held the BTC and the value you have after withdrawing from the pool is the impermanent loss.

A Numerical Example

Let's look at the numbers more closely.

Initially:

1 ETH = $1000
1 BTC = $1000
Total Value = $2000

After Price Change:

1 ETH = $1000
1 BTC = $2000

The AMM rebalances. The exact amount you receive upon withdrawal depends on the AMM's formula (often a constant product formula), but let's assume for simplification, you now have:

0.707 BTC
1.414 ETH

Your new total value: (0.707 * $2000) + (1.414 * $1000) = $1414 + $1414 = $2828

If you had just held your initial 1 BTC, it would now be worth $2000. You gained $828 in the pool, but you would have gained $1000 by holding! The difference ($172) represents the impermanent loss. *Note: these numbers are simplified for illustration.*

Comparing Holding vs. Providing Liquidity

Here's a table summarizing the potential outcomes:

Scenario	Holding (HODLing)	Providing Liquidity (LP)
Price of BTC Doubles, ETH Stays Constant	$2000 (Profit of $1000)	$2828 (Profit of $828 - Impermanent Loss)
Price of BTC Stays Constant, ETH Doubles	$2000 (Profit of $1000)	$2828 (Profit of $828 - Impermanent Loss)
Prices Stay the Same	$2000 (No Profit/Loss)	$2000 + Trading Fees (Small Profit)

How to Minimize Impermanent Loss

While you can’t eliminate impermanent loss entirely, you can take steps to reduce it:

**Choose Stable Pairs:** Providing liquidity to pairs with assets that tend to move in the same direction (like stablecoins – USDT, USDC – paired with other stablecoins) will result in lower impermanent loss.
**Consider Pools with Lower Volatility:** Pools involving established, less volatile assets are generally safer.
**Monitor Your Positions:** Regularly check the value of your liquidity pool position to see if impermanent loss is becoming significant.
**Understand the AMM:** Different AMMs (like Uniswap, SushiSwap, PancakeSwap) have different formulas, which impact impermanent loss. Research the specific AMM you’re using.
**Long-Term View:** If you believe the assets will revert to their original price ratio, impermanent loss may be temporary.

Popular AMMs and DEXs

Here's a quick comparison of popular platforms:

DEX	AMM Type	Key Features
Uniswap	Constant Product AMM	Leading DEX on Ethereum, simple to use.
SushiSwap	Constant Product AMM	Fork of Uniswap, offers additional rewards.
PancakeSwap	Constant Product AMM	Popular DEX on Binance Smart Chain, lower fees.
Balancer	Flexible AMM	Allows for liquidity pools with more than two assets.

Practical Steps to Get Started

1. **Choose a DEX:** Research and select a reputable DEX. Register now Start trading Join BingX 2. **Connect Your Wallet:** Connect your MetaMask or other compatible wallet to the DEX. 3. **Select a Liquidity Pool:** Choose a pool with assets you understand and are comfortable with. 4. **Provide Liquidity:** Deposit an equal value of both tokens into the pool. 5. **Monitor Your Position:** Regularly check your position for impermanent loss. 6. **Withdraw Liquidity:** When you feel the time is right, withdraw your liquidity and claim your earned fees.

Further Resources

Conclusion

Impermanent loss is a complex but crucial concept to understand when participating in DeFi. By understanding the risks and taking steps to minimize them, you can increase your chances of successfully providing liquidity and earning rewards. Remember to always do your own research and never invest more than you can afford to lose.

Recommended Crypto Exchanges

Exchange	Features	Sign Up
Binance	Largest exchange, 500+ coins	Sign Up - Register Now - CashBack 10% SPOT and Futures
BingX Futures	Copy trading	Join BingX - A lot of bonuses for registration on this exchange

Start Trading Now

Register on Binance (Recommended for beginners)
Try Bybit (For futures trading)

Learn More

Join our Telegram community: @Crypto_futurestrading

⚠️ *Disclaimer: Cryptocurrency trading involves risk. Only invest what you can afford to lose.* ⚠️

Impermanent loss

Contents