What is an Impermanent Loss and How to Avoid it

Imagine lending your assets to a trusted person only to get them back devalued and reshuffled even though the other person didn't steal anything. This loss is what is known as an impermanent loss in the defi world.  

Not a scam, not a fraud, and not even a hack - it is simply a hidden cost of playing the role of a market maker in the decentralized finance world. So, basically, if you are providing liquidity, you stand at a silent risk at all times. The benefits, though, are so lucrative that it is worth the risk.  

So, let's learn about what is impermanent loss and understand the right strategy so you can outsmart it!  

What Is Impermanent Loss?

Let's start with the basic definition; impermanent loss is a common phenomenon in the AMMs that rely on algorithms to manage liquidity and trades. It occurs when you, as a liquidity provider, add liquidity to any decentralized exchange and the price of tokens you deposited changes as compared to when you deposited them.

Why it is known as 'impermanent' loss is also very interesting. It is because the loss is not locked unless you withdraw your tokens while the prices are still unbalanced. In case the token prices return to their original state before you withdraw, the loss can shrink or disappear entirely.

How Does Impermanent Loss Happen?

Now let's talk about how impermanent loss in liquidity pools happens.  

• Tokens are deposited: As a liquidity provider, you are required to provide two sets of assets (like USDC and ETH) of equal value into a liquidity pool.  
• Price shifts cause asset ratio to rebalance: If the price of a token falls or rises, the pool automatically adjusts the ratio of tokens to maintain balance.
• Arbitrage traders create the discrepancy: Traders take advantage of these price differences between the pool and the open market. This causes your share of the pool to shift.
• Final withdrawal = less than HODLing:  When you withdraw, the total value of your assets is often lower than if you had just held them in your wallet.

So, now the question will be how you can calculate an impermanent loss. As an example, see the following.

• Say, you provide 1 ETH ($2,000) and 2,000 DAI into a liquidity pool. So, the total value will be $4,000.
• Now, assume ETH rises to $3,000. The liquidity pool will automatically adjust the balance - reducing your ETH share and increasing your DAI share.
• As a result, you now hold fewer ETH and more DAI, even though the total pool value increased.

So, basically if you had just held 1 ETH and 2,000 DAI, you’d now have $5,000. But due to the rebalancing, your share might be worth only around $4,800.  

That $200 difference is your impermanent loss.

You can use tools like impermanentloss.app or dailydefi.org to estimate loss based on price changes.

Factors That Influence Impermanent Loss

There are many factors that influence the impermanent loss defi that you may face. These factors include:

Volatility: Bigger Swings = Greater Risk

The impermanent loss is directly tied to price divergence between the tokens of the liquidity pair that you have provided. The greater the volatility between the pair, the more pool needs to rebalance. If one token doubles in value while the other stays the same, you often suffer great impermanent loss.

Holding Time: Longer Time = More Exposure

The longer your funds stay in the liquidity pool, the greater the time there is for prices to shift, especially when operating in a volatile market. If prices don't return to their original ratio, the impermanent loss in liquidity pools is more likely to be realized when you withdraw. This helps you gain greater exposure for your liquidity.

Trading Fees: May Offset Loss

Every single trade in the liquidiy pool generates a share of fees for the liquidity provider. If the pool you have added token in has higher trading volume and decent fees, the earnings you receive can sometimes outweigh the impermanent loss. Due to this reason, mostly liquidity providers remain in profited situations despite the impermanent loss.

Market Trends: Bull/bear Cycles Affect the Value

Broader market movements, which are usually out of our control, can either reduce or amplify impermanent loss. An excellent example would be Trumps recent crypto reserve strategy. This resulted in major price fall for many crypto currencies including ETH. Moves like this can lower or increase the impermanent loss for you.

How to Avoid or Reduce Impermanent Loss

Now that you know what is impermanent loss, you’d understand that it can’t be eliminated entirely. But you can definitely utilize strategies to avoid or reduce its impact. Here how to avoid impermanent loss:

1. Use Stablecoin Pairs

Use stablecoins, like USDC/DAI or BUSD/USDT, to avoid extreme volatility. Stablecoins are specifically designed to maintain a fixed value so since they rarely diverge, there is a high chance your pool with require minimal rebalancing. These pools offer low risk as well as a steady income fee. However, the yields are typically low, but it is best for risk-averse users

2. Pick Correlated Assets

Correlated tokens tend to move in the same direction. So, if one increases in value, the second tends to move along. For instance, ETH/stETH and WBTC/ BTCB are highly correlated so the chance of significant price divergence, and thus IL, is lower.

3. Try IL Protection Platforms

Some defi platforms offer built-in impermanent loss insurance which often comes with trade-offs like lock-in periods, lower flexibility, or protocol-specific rules. If you are worried about extensive IL, try these platforms.

4. Earn Extra Rewards

Many liquidity pools offer bonus token incentives for contributing to their liquidity pool. These extra earnings are paid in the platform's native token, and can help you offset your impermanent loss in defi, especially in high-yield opportunities. You can then reinvest your rewards for compound returns.

5. Diversify Pools

Much like traditional investing, diversification helps in the defi world as well. What it means is you can split your liquidity across multiple pools according to the potential impact of impermanent loss. Doing so will help you track performance of each pool individually and reallocate your assets based on returns.

Final Words

Impermanent loss is one of the most misunderstood risks in DeFi, but with the right knowledge and tools, it's entirely manageable. Whether you’re a seasoned liquidity provider or just getting started, understanding how price divergence affects your assets can save you from unpleasant surprises. By choosing stable or correlated pairs, leveraging protection tools, diversifying your liquidity, and actively monitoring your positions, you can protect your capital and even turn a profit.