Understanding Impermanent Loss and How to Prevent It in Crypto Trading
The concept of impermanent loss is not hard, even for someone entirely new to the crypto market. Merely dissecting the phrase, one can understand it to mean a loss that is not permanent. However, there is more to what impermanent loss means in the crypto sense of things beyond the obvious grammatical translation.
That said, let’s delve into the topic by first describing the underlying concept of impermanent loss in the crypto market.
Understanding Impermanent Loss
In addition to what was described earlier, an impermanent loss is used to describe the noticeable changes in liquidity investment from the point of deposit and withdrawal.
Notably, this type of price difference is negative and usually happens when the value (i.e. price) of a token deposited in a liquidity pool declines from the amount it was at the time of deposit. More so, the larger the change or difference in token value, the bigger the trader’s exposure to impermanent loss.
That said, although the term impermanent loss is a term used across all financial markets, it is also used in the crypto market and most commonly used among DeFi traders, particularly those involved in yield farming.
The reason why impermanent loss is common among yield farmers is that they are mostly required to either stake or invest in a reserved liquidity pool (LP), an attribute that is peculiar to a special kind of crypto market known as an automated market maker (AMM).
Although it can be highly profitable, providing liquidity to an LP also comes with great risk exposure, one of which includes impermanent losses, thus the need to understand the underlying concept. But first, what’s the relationship between impermanent loss and the automated market maker?
To begin with, Market Makers (regardless of the financial market) are generally responsible for injecting liquidity into a specific market and maintaining this position throughout a trading period, which could be an hour, day, week, month, and in some cases, a year or more.
In this context, a Market Maker is responsible for injecting liquidity into a DeFi protocol’s liquidity reserve where other traders (i.e. borrowers) can take loans, trade with it, and subsequently return alongside a prespecified interest.
While anybody can contribute to the funding of this liquidity reserve (or LP), interested investors instantly become market makers and are rewarded with the commission from trading fees as well as an expected annual percentage yield (APY) at the conclusion of each investment period.