What is Impermanent Loss? Clear explanations and calculations! =

If you are interested in Decentralized Finance (DeFi) and more specifically looking to gain returns on your crypto coins, you may have come across the term Impermanent Loss . This is a risk often brought up in the context of liquidity provision and yield farming.

But what exactly does it entail, how do you calculate your risks and is it really that dangerous compared to the returns you sometimes get? We decipher all this together in this article and tell you how most investors protect themselves against this.

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  • What is Impermanent Loss?
    • An example of impermanent loss
  • This is how you calculate the Impermanent Loss yourself
    • For instance
  • Some tips to avoid the permanent loss
  • How can you lose money with crypto trading?
  • What is Uni Swap?
  • Disclaimer

What is Impermanent Loss?

When you provide liquidity to MAs (platforms like Uniswap), you expose yourself to the volatility of these platforms and the cryptocurrencies found here. You will of course receive the trading fees as a reward, and sometimes extra incentives with yield farming between the different DeFi protocols.

Suppose Jan deposits 50 NEO and 10 ETH on the Uniswap platform in the form NEO/ETH. He will then deposit his LP Tokens on Sushiswap himself to obtain SUSHI.

The permanent loss (impermanent loss) occurs when one of the pair’s two assets becomes volatile. If the ratio is no longer the same as when you provided the liquidity, you will exit with a different number of assets. That is, compared to simply holding the assets, you will have lost value.

An example of impermanent loss

Let’s take John as an example again. He deposited those 50 DASH (value $100/DASH) and 5 ETH (value $1000/ETH), or $10,000 in cash on the Uniswap AAVE/ETH pair. The value of DASH then rises sharply, by 50% to $150 and Jan decides to get out, only to take a profit.

He will receive a different ratio at the exit: only 33.3 DASH and 6.12 ETH, ie $12,240. Do you find it difficult to follow like this? We will now show you the exact calculation so that you better understand what we mean.

This amount ($12,240) is an added value compared to the original situation, because he had deposited $10,000. However, if he had just “held” (kept his wealth) he would have had $12,500.

That’s a $360 loss. We see that this $360 of non-profit is likely to be offset by the various returns that the liquidity injection can bring.

Be careful, because the Impermanent Loss does not take into account the potential profits you can make by taking your liquidity to a protocol (trading commissions, farming rewards from yields, airdrops…). Bringing liquidity to low or volatile pairs through risk management can be profitable. But it is important that you are aware of the risks and adjust your strategy accordingly.

 

This is how you calculate the Impermanent Loss yourself

Of course, you cannot predetermine the price movements of the crypto coins in a pair. For example, you cannot know in advance whether and how big the loss is that you will take on a coin. However, you can calculate the impermanent loss yourself. And that is not that difficult at all.

We’ll move on to help you understand how IL really works and how we can calculate it ourselves using the Uniswap example. A Uniswap pair consists of two liquidity reserves, the pair’s two assets. To determine how many assets we would exit after a change in value, all we need to do is calculate the number of assets in each of the reserves when buying and when selling, and then compare them.

For instance

Let’s take the DASH/ETH pair. If the total liquidity remains constant, the number of assets in the reserves will change with each exchange :

Reserve of Ethers * Reserve of Dash = Initial Liquidity

We can use the pair to determine the price of Ether based on the number of chips we receive in a transaction this way. This is the formula used by Uniswap to determine the price in an exchange.

Ether price = Dash reserve / Ether reserve

Using these two equations, in our stable liquidity example, we can perform the following operations to understand the impact of volatility on the reserves of the pair’s assets.

Ether reserve = SQRT (initial liquidity / Ether price)

Dash reserve = SQRT(initial liquidity * Ether_price)

We can use these formulas in Jan’s examples. Jan deposited 50 Dash and 5 Ether, meaning he held 10% of the pair’s liquidity reserves. The price of the Dash increases and 1 Ether is no longer worth 10 Dash, but 6.66 Dash. The pair therefore has a total liquidity reserve of $100,000.

Constant liquidity = 500 * 50 = 25,000. (500 Dash and 50 Ethers in the pair)

Ether reserve = SQRT(25,000 / 6.66) = 61.26 Ethers

Dash Reserve = SQRT(50000 * 6.66) = 408.04 Dash

So if John withdraws his cash, he would leave with the famous 6.12 Ethers and 40.8 Dash presented in the first example. It is then also possible to plot such a thing in a graph, so that it becomes a lot clearer. Many analysts use this method.

 

Some tips to avoid the permanent loss

If you don’t want to take the risk of Impermanent Loss and still want to use your capital to provide liquidity on certain AMMs, there are some tips on how you could avoid a possible loss. These tips are often used in practice.

  • Use stable trading pairs. A pair between two stablecoins, for example, or a stablecoin and a major asset such as Ethereum.
  • Provide liquidity through Balancer. The Balancer platform makes it possible to bring liquidity, not at 50/50 like Uniswap, but at 80/20 or even 95/5.
  • You now know all about Impermanent Loss, these existing risks can nevertheless be minimized when you bring liquidity into decentralized finance protocols.

How can you lose money with crypto trading?

On the internet you can read various stories of people who have made a lot of money with crypto trading. These stories are popular, and more and more people get interested in crypto trading and decide to start with it. However, it is important to know that you can also lose a lot of money with crypto trading. That usually happens when one does not have enough understanding about what he is doing. For example, there are people who do not yet know what a crypto coin is, and who will invest a lot of money in it. Purely because everyone is so excited about cryptocurrency, and the value is increasing.

That is why more and more people choose to follow a crypto course before they start trading cryptocurrencies. You then know much better what you are doing, and can therefore better estimate when it is the right time to buy (and sell) a crypto coin. The chance of making a profit then becomes many times greater.

It is possible to lose money with crypto when you sell a crypto coin for a value that is lower than the purchase amount. Do you buy a coin for 100 euros, and then sell it for 90 euros? Then you have made a loss of 10 euros. Of course, making a profit works the same way, but in the other direction.

What is Uni Swap?

Impermanent Loss is a concept that you mainly encounter in combination with Uniswap (or other decentralized crypto trading platforms), which is a decentralized crypto exchange. It is therefore also called a DAO, which stands for Decentralized Autonomous Organization (Decentralized Autonomous Organization). You can also often find Uniswap under the category DEX, which stands for Decentralized Exchange.

Uniswap runs on a blockchain, and is therefore completely decentralized. That is fairly unique, given that there are not that many crypto exchanges that work completely decentralized. Most crypto exchanges still run on central systems. It is very difficult to set up a decentralized crypto exchange, as liquidity is needed. Because it is completely decentralized, the network has to provide liquidity, and that is not often possible. At the moment there are therefore many more central crypto exchanges than decentralized crypto exchanges.

Other well-known Decentralized Exchanges are Sushiswap and PancakeSwap. Just like Uniswap, they run on a blockchain, which makes them unique crypto exchanges. The advantage of these exchanges is that you are not dealing with an actual organization. This gives the network much more influence over the future of the blockchain and the exchange. There is also often much more possible with a decentralized crypto exchange. Such an exchange is much more flexible than a central exchange, which is supported by an entire organization. Many new crypto coins are first available on a DEX, before they are for sale at central crypto exchanges such as Binance, ByBit and Bittrex.

Disclaimer

“Everything I say or write is purely general information and is intended as general information only. It does not contain any investment advice or an offer, invitation or recommendation to buy or sell any financial instrument or to enter into any other transaction. We are not professional financial advisors. If you want to invest in crypto, only invest money that you are willing to lose, because the chance of losing it is always there. We are not responsible for the investment choices you make, the only person responsible for this is you yourself.”

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