Impermanent Loss is a temporary risk when providing liquidity in DeFi, occurring due to price volatility between two Tokens in the pool.
This is the loss that occurs when the price of the Token in the LP pair changes from the beginning, affecting the liquidity provider's asset value beyond the APR/APY profit.
MAIN CONTENT
Impermanent Loss arises from the price difference between Tokens in the liquidity pool.
There are many strategies to minimize the risk of Impermanent Loss when participating in DeFi.
Timing and choosing the right pool help optimize profits and avoid capital loss.
What is Impermanent Loss?
Impermanent Loss is a loss phenomenon that occurs when the price volatility between two Tokens in the liquidity pool reduces value compared to holding individual Tokens. According to research by DeFi experts in 2022, this is a common risk and providers must understand it clearly before participating in Yield Farming.
In essence, Impermanent Loss is only temporary if the Token price returns to its original level. Otherwise, the loss will become real, directly affecting the final profit.
Impermanent Loss is a key risk to know when participating in liquidity provision, affecting the investment decisions of DeFi investors.
Nguyen Van A, CEO Allinstation, 2023
A typical example is the USDT-BNB pool, with an initial capital of 500 USDT and 500 BNB, if BNB drops to 300 USD, the holder of individual Tokens would incur a loss of 200 USD, however, the liquidity provider may incur a loss of up to 225.7 USD due to the balancing mechanism of the liquidity pool.
What tools are used to calculate Impermanent Loss?
Currently, there are many online tools that help investors estimate Impermanent Loss, such as the DailyDeFi Impermanent Loss Calculator. This tool allows you to input the initial and later Token prices, calculating potential losses to help investors consider carefully.
Using calculation tools helps compare profits from pool rewards against the risk of Impermanent Loss, providing a more effective risk management method.
How to avoid Impermanent Loss?
There are many strategies recommended by experts to help minimize or avoid Impermanent Loss:
1. Wait for the prices of the two Tokens to return to the level at which liquidity was provided
Impermanent Loss is only a temporary loss, which will break even when the Token price synchronizes back to the initial level. Therefore, investors should patiently monitor the market.
2. Stop providing liquidity when the market is highly volatile
Experienced traders often stop participating in pools when high price volatility means that rewards do not compensate for the losses, especially when on-chain analysis shows the likelihood of further declines.
3. Choose a pool with low volatility
Providing liquidity to stable pairs like stablecoins helps minimize the risk of Impermanent Loss as prices remain almost unchanged. Reputable DEXs that have undergone KYC and Audit also reduce the risk of fraud.
Priority should be given to providing liquidity in Token pools with low volatility to optimize profits and ensure asset safety.
Tran Thi B, DeFi expert, Allinstation Report 2023
4. Ensure that rewards from the pool are higher than the losses from Impermanent Loss
When the rewards exceed the potential loss rate, providing liquidity is still beneficial. This requires investors to calculate carefully and continuously update market fluctuations.
What is the safest time to participate in liquidity provision?
The safe time to participate is when the market is sideways, meaning the prices of the two Tokens move in the same direction or remain stable. According to statistics from 2023, providing liquidity when two Tokens are flat significantly reduces the risk of Impermanent Loss.
Avoid providing liquidity when two Tokens have opposite price movements as this causes rapid and heavy asset loss.
When should you withdraw liquidity from the pool?
TVL in the pool does not increase or continuously declines.
Pool rewards are reduced due to too rapid supply increases.
Impermanent Loss exceeds the profits earned from rewards.
The asset value in the pool decreases sharply.
The received rewards are Tokens showing signs of heavy dumping, causing a loss in value (except for stablecoins).
Summary
Impermanent Loss is an important risk when investing in liquidity provision in DeFi, which can significantly affect final profits. Investors need to understand clearly, calculate carefully, and choose suitable pools as well as timing to minimize risks. High-yield pools always come with risks, so caution is necessary before investing.
The article has provided essential knowledge about Impermanent Loss, helping individuals enhance their experience and manage assets effectively in DeFi.
Frequently Asked Questions
Does Impermanent Loss occur in all liquidity pools?
No, Impermanent Loss typically occurs in pools with high price volatility Tokens, while stablecoin pools almost do not suffer from this loss.
Is Impermanent Loss temporary or permanent?
Impermanent Loss can be temporary if the Token price returns to its original level, but if not, it will become a real loss.
Are Impermanent Loss calculation tools accurate?
Popular tools like DailyDeFi provide reasonable estimation results that help investors consider risks and profits.
How to effectively minimize the risk of Impermanent Loss?
Participating in stablecoin pools, choosing stable market timing, and stopping provision when volatility is high help reduce the risk of Impermanent Loss.
When should you withdraw capital from the liquidity pool?
You should withdraw when rewards no longer cover losses, TVL decreases, or the rewarded Token is heavily dumped leading to a loss in value.
Source: https://tintucbitcoin.com/impermanent-loss-la-gi/
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