Something about Impermanent Loss (IL) on every AMM DEX you should know

Impermanent Loss, or IL, is no longer a new concept, this article will focus on explaining why IL exists, how IL works, thereby limiting the unwanted effects it brings.

To understand IL, we first need to answer the following questions:

1/ What is AMM, why do we need it?

AMM and Decentralized exchange (DEX) appears to solve one of the major problems in the crypto industry, the liquidity problem, especially low-cap projects, which have not had the opportunity to list on CEX exchanges due to the extremely expensive cost. AMM or Automated Market Maker is simply an automatic order matching mechanism on DEXs, where buyers and sellers trade at the market prices, unlike CEX exchanges where users can place buy/sell orders.

2/ What is a Liquidity Provider (LP) doing?

Their duty is similar to the Market Maker on CEX, i.e. if traders sell, LPs will buy and vice versa. This looks like when you are depositing money in a bank, then doing nothing. A bank will pay interest (APR), but you completely don’t know how the money is used.

3/ How is AMM different from MM

Different in letter A, for sure :)) but more than that. AMM is a passive MM mechanism, the letter A here means this.

However, unlike MM on CEX, which has the authority to place buy/sell orders and decide on size, order quantity, and price. LP merely provides liquidity to the market, the rest is completely decided by the trader. It is the difference in mechanism between AMM and MM that leads to the emergence of IL.

4/ How does IL take place?

Ok, so we have grasped the basic concepts that lead to the appearance of IL. Now I will use Buni pool, BUNI - BUSD (*Note: 1 BUSD = $1) to better clarify how IL works.

Suppose:

  • Stake 500 Buni, at the price of $0.2, equivalent to $100 worth.
  • Then the price of Buni x2 from 0.2 - $0.4

So if we hold this amount of Buni we will have $200. However, if staked in the pool, it will definitely never reach $200, so why is there this shortfall? The following pics outlines this process in more detail:

5. Conclusion

The disparity between doing HODL and LP (as we call IL) comes about because of the difference between the average price of holding tokens and doing LP.

When holding, you execute only 2 orders: Buy at 0.2 and sell at $0.4

Doing LP means executing a lot of small orders. It also explains why it is not possible to calculate the IL with absolute accuracy since we do not know the exact average price and how many orders are executed in this price range.

6/ How to limit IL?

If you belong to the group of new investors, attracted by the sky-high APR of projects. A few tips are:

  • DYOR, YES! as always
  • Avoid providing new Liquidity when the market is highly volatile, use Impermanent Loss Calculator to calculate the probable IL
  • Projects with small volume/cap often have attractive APR to compensate for IL and come with higher price volatility.

In addition, you can also restrict IL when

  • Deposited and withdrawal prices are the same, but this rarely happens
  • Using at least 1 stable coin token in your pair, thereby reducing the risk when the market fluctuates sharply.

Last but not least, hedge your fund carefully, even when you are a risk-loving investor. This is always true for a very risky investment channel like crypto.

1 Like

Woww nice! Thank you for your precious sharing.
Many members need to read this :star_struck: