A lot of smart contracts are now providing a plethora of opportunities to multiply your capital. Providing liquidity is one of the ways gaining momentum these days. If you’re a liquidity provider, you probably heard about impermanent loss. If not, this is something everyone has to reckon with. What is impermanent loss? How to avoid impermanent loss and capitalize on your assets to the maximum? Let’s break it down.
What is Impermanent Loss?
Impermanent loss or divergence loss is the unrealized loss that occurs when you provide liquidity to a liquidity pool and your deposited assets change in price compared to the moment you deposited them. The more they change, the higher the risk of impermanent loss is.
- Impermanent loss is temporary as long as the fee rewards you earn compensate for the losses and/or the price returns to its initial level.
- If you remove your funds from the pool before their value is restored, the impermanent loss will be realized and become permanent!
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How Does Impermanent Loss Work?
By providing liquidity to a liquidity pool, you allow traders to use your liquidity so they pay you a small fee. The fees are basically split up among all the liquidity providers based on a portion of funds you contributed.
Imagine you provided liquidity to a pool of tokens that was worth $1,000. The approximate APR is 10%. In the ideal scenario, at the end of the year you will have $1,100. However, what if the token’s price dropped by half and you end up owning only $550 worth? In this case, even if you earned profit from trading fees, your total investment plummeted.
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When Does Impermanent Loss Happen?
Impermanent loss is always about changing your share of a liquidity provider position:
In a nutshell, impermanent loss won’t happen if both tokens don’t change at all or both increase in value.
How to Avoid Impermanent Loss?
Let’s get to the nitty-gritty on how liquidity providers can avoid or minimize impermanent loss.
#1 Provide Liquidity For Stablecoins
You might be aware why providing liquidity to a stablecoin pair might be a help in minimizing impermanent loss risks. Obviously, stablecoins are cryptocurrencies which are pegged to the real-world assets and don’t change much in value. Well, if you go for a stablecoin pair, such as USDT/USDC or BUSD/USDC etc, you will certainly avoid impermanent loss or at least minimize it as much as possible.
#2 Avoid Risky and Highly-Volatile Assets
Risky or newly-launched projects can increase the risk of an impermanent loss, and the reason is totally clear: one of these tokens might suddenly drop or soar up. Even if a newly-released token you choose has a lot of prospects for the future, you’d better not provide liquidity with this one. Considering the fact that we have to keep both tokens at the same value, even a positive price movement of one token won’t lead us to the expected result with minimum or no impermanent loss. The impermanent loss risk will be minimized only when a coin moves in price rarely.
#3 Choose Low-Priced Coins
There are tokens going through a bear market, so pay attention to those. Even if an impermanent loss happens, your total value of tokens will rise up.
#4 Go For Extra Incentives
Some DEXs offer you extra incentives while providing liquidity. For instance, on
- Provide liquidity to a pool of tokens and earn fees from trading.
Algebra offers only 1 pool with a dynamic fee model that calculates fees based on risks, volatility of the assets, trading and pool volumes, thus finding the right balance between traders and liquidity providers and minimizing impermanent loss and price slippage as well.
- Earn extra profit from farming your tokens.
On Algebra, you can farm your provider liquidity token. The APR can reach up to 300% at Limit Farms and up to 70% at Infinite Farms and regularly maintains high levels on the platform.
- Stake crypto and earn rewards
Besides built-in farming, Algebra offers you to stake your extra tokens so that they don’t sit on a fence but earn rewards for you and multiply your overall capital.
Let’s make an upshot:
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You provide liquidity for a pool of tokens and earn approximately 2% from trading fees.
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You participate in farming with 30% APR; if taking the low limit.
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You stake your ALGB tokens earned after farming and get 130% APR.
2%+30%+130%=162% overall APR that you can get on this platform. Imagine that you’ve provided liquidity to a pair of stablecoins which means you probably won’t experience impermanent loss at all, and just make a good profit! Sound’s good, doesn’t it?
Even if impermanent loss remains a huge deterring factor for most liquidity providers, you can get it solved by the ways described in this article.