Impermanent Loss Explained: Minimize Risk, Maximize Rewards

Impermanent loss is a major concern for people looking to earn passive income in crypto. It is a risk that plagues all liquidity providers, but it can be countered by thoroughly understanding why impermanent loss occurs, and what can be done to minimise it.

Key Takeaways

• AMMs are responsible for liquidity in DEXs, and they do this with the help of liquidity pools.

• Impermanent loss occurs when the value of your tokens in the pool change due to market volatility.

• Impermanent loss can be dealt by investing in less volatile pairs, good liquidity pools, and staying updated about markets can help deal with the losses.

Before we get started, here is some food for thought. Impermanent Loss - Is it truly impermanent if it is a loss? Or is it even a loss if it is impermanent?

What are Automated Market Makers (AMMs)?

AMMs are software that can control the liquidity and pricing of tokens in a DEX to ensure sufficient liquidity; they do this by buying and selling tokens to make up for market movement.

What are liquidity pools and liquidity providers?

Liquidity pools supply the required liquidity for a DEX, and AMMs rely on these pools to work efficiently. Liquidity providers are people who contribute tokens to the liquidity pools, and they earn passive income from it.

What is impermanent loss? How can you estimate the loss?

Impermanent loss is a temporary loss that occurs due to market volatility. When the price of a token changes, it leads to impermanent loss. Ideally, you want the value of your tokens to remain unchanged between the time of investment and withdrawal.

Things may seem confusing at this point…

The value of a token will definitely change over time, does that mean impermanent loss is inevitable? How is it impermanent then?

Let’s understand what actually happens.

When you choose to invest a token pair in a liquidity pool, for example, ETH/USDT, you are required to invest in a 50:50 ratio. Initially, both the pairs contribute equally to the pool. However, if the value of ETH increases compared to USDT, the ratio of the pair changes due to arbitrage and the pool’s algorithms.

Now, if you were to withdraw your tokens at this point, you would receive lesser ETH and more USDT. This change in value is what leads to impermanent loss.

Note: Had you held onto ETH outside of the pool, it might have yielded a higher return.

Well, if you don’t withdraw your funds at the point of high volatility, the loss is not realised and it will remain impermanent. If market volatility drives the price back to what it was when you invested it, your loss will vanish. However, when this isn’t the case, impermanent loss will become inevitable; in such cases, you can use this formula to estimate the impermanent loss.

Where IL = Impermanent loss, k = price ratio between the current value and value at the time of investment.

How to manage impermanent loss?

Impermanent loss shouldn’t discourage a person from participating in liquidity pools. The fees and rewards you earn for investing in liquidity pools help you offset any potential impermanent loss. Smart investors are able to manage their investments so that they earn heavy profits through the fees and rewards DEXs give them for their liquidity.

Here are some tips to keep in mind while investing in liquidity pools:

• Volatile Pairs: Investing in less volatile markets such as stablecoin pairs can help manage impermanent loss.

• Liquidity pool composition: A liquidity pool with pairs of low volatility and high correlation tends to suffer less from impermanent loss.

• Market movement and time frames: Being aware of the time frame of your investment and predicting the market movement can help you mitigate risks of impermanent loss.

• Latest developments: If you are generally aware of the latest developments in the industry, it could help you enter during opportune moments and exit from dangerous situations.

How to profit from Liquidity Pools?

You can be rewarded for your liquidity in multiple ways:

1. Native tokens

2. Governance tokens

3. Cryptocurrencies and stablecoins

4. NFTs and other rewards

When you are looking to invest in liquidity pools, please weigh the yield/rewards they promise against the impermanent loss expected from those pairs. Diversifying your portfolio across different pools and token pairs can also help you mitigate impermanent loss risks.

Conclusion

Impermanent loss can seem detrimental to your investment plans. However, with proper research and a bit of practice, you will be able to find the right opportunities to earn from providing liquidity.

If you are also looking for other opportunities to earn passively from crypto, consider looking into Multipli fi. It is a secure and simple platform that can generate yield on your stablecoin and RWA assets.