5 most effective ways to manage or avoid impermanent loss

A wise crypto sage once said the fear of impermanent loss (IL) is the end of liquidity mining.

Why?

Because some people avoid liquidity mining altogether because of impermanent loss.

But you don’t have to.

In this post, I will share with you how to manage or eliminate impermanent loss without losing out on yield farming.

But first, let’s talk about liquidity mining pools where the impermanent loss occurs.

Understanding liquidity mining pools

To understand impermanent loss, you need to know what liquidity mining is and how liquidity pools work.

In standard liquidity mining pools, you have to deposit two different tokens of equal value.

For example, in the CST-BNB liquidity pool on PancakeSwap, you have to deposit both CST and BNB of equal value to participate in liquidity mining.

That means if you want to invest $1,000 in the pool, you must deposit $500 worth of CST and $500 worth of BNB into it.

As a liquidity provider (LP), you earn a share of all trading fees generated from buying and selling the tokens in the pool.

Now, when people buy more CST from the pool using BNB, the price of CST goes up relative to BNB.

So, the amount of CST you have in the pool reduces while your BNB amount increases as people take more CST from the pool and leave you with their BNB.

This is where impermanent loss sets in.

What is impermanent loss?

Impermanent loss is the difference in the value of your crypto assets between when you hold them in your wallet and when you add them to a liquidity pool on a DEX.

Would you have made more money by holding your crypto assets in your wallet compared to adding them to a liquidity pool?

If yes, then the difference is the amount of impermanent loss you incurred.

It is “the cost of doing business in liquidity mining” and is only realised when you withdraw your tokens from the pool.

An example of impermanent loss

Say you added $500 worth of CST and BNB to the pool, and you now have an LP token worth $1000.

For the purpose of simplicity, let’s assume the current price of CST is $1 per token and BNB is $2 per token.

So, you have 500 CST and 250 BNB in the liquidity pool now.

Over time, the price of CST goes to $5 and BNB to $3 (these are only hypothetical examples).

If you had held your 500 CST and 250 BNB in your wallet, they will both now be worth 2,500 and $750 respectively.

Giving you a total of $3,250

But since you added them to the liquidity pool, you now only have 213 CST worth $1,065 and 355 BNB also worth $1,065.

Giving you a total of $2,130.

Clearly, you have incurred an impermanent loss of $1,120.

You would have made more money if you had held your tokens in your wallet instead of adding them to the liquidity pool.

Factors that affect your impermanent loss

1. The price volatility of the assets in the liquidity pool

The more volatile the crypto assets in the liquidity pool, the more likely you are to incur an impermanent loss.

This is because the prices of the assets in the pool are more likely to diverge, which will lead to a difference in the value of your LP tokens.

2. The ratio of the assets in the liquidity pool

If you provide liquidity to a pool with a 50/50 ratio of two assets, you are less likely to incur impermanent loss than if you provide liquidity to a pool with a 70/30 ratio.

This is because a 50/50 ratio is more stable than a 70/30 ratio, which means that the prices of the assets in the pool are less likely to diverge.

This is assuming both tokens are volatile assets (no stablecoins).

But if the dominant token is a stablecoin, the impermanent loss will be less pronounced.

3. How long you keep your assets in the liquidity pool

The amount of time you keep your assets in the liquidity pool can have both a negative and positive effect on your impermanent loss.

For example, the longer you keep your assets in the liquidity pool, the more likely the prices of the assets are likely to diverge, leading to impermanent loss.

On the positive side, the longer you leave your tokens in the liquidity pool, the more likely you’re to earn enough fees to offset any impermanent loss.

More so, given sufficient time, the price of the tokens can return to their original levels.

5 ways to manage or avoid the impermanent loss

You can manage and even completely eliminate the risk of impermanent loss by following these tips.

1. Single-token staking or one-sided liquidity pools
2. Invest in high APY pools
3. Add liquidity to stablecoin pools
4. Provide liquidity to low-volatility pairs
5. Invest in flexible liquidity pools

1. Single token staking or one-sided liquidity pools

The best way to completely avoid impermanent loss is to only invest in single token staking or one-sided liquidity pools.

Single token staking pools allow you to stake a token to earn more of the same or a different token as a reward.

Impermanent loss only occurs in liquidity pools where you have to supply two or more tokens.

So, if you invest in single token staking or a one-sided liquidity pool, you completely eliminate the risk of impermanent loss.

2. Invest in high APY pools

You can manage impermanent loss by investing in liquidity mining pools with high APYs.

Given sufficient time, the high APY can help you earn enough fees to offset the impermanent loss.

But don’t chase high APY pools alone with no consideration for the quality of tokens involved.

Personally, to minimise risks I only look for high APY pools with blue chip coins or tokens, especially those with stablecoin pairs.

For example, BTC-USDT, ETH-USDC, BTC-ETH, and similar pools.

If you find an APY of 10% or high for these pools, I think you should grab them.

Some of the best places to find high APY pools across multiple chains and protocols include Nanoly, Beefy, Tulip, etc.

3. Add liquidity to stablecoin pools only

Another way to completely avoid impermanent loss is to only provide liquidity to stablecoin pools.

Stablecoins are less volatile assets with their prices pegged to $1.

So, their values will always remain the same, except for occasional and temporary insignificant deviations.

4. Add liquidity for low-volatility assets

You can minimise the risk of impermanent loss by only providing liquidity for blue chip tokens with high market caps.

Popular assets with high market caps or liquidity are usually less volatile compared to low-cap tokens.

Examples, include BTC and ETH.

More so, they’re less likely to become scams and are therefore safer. But they tend to have lower rewards due to many people investing in them.

5. Invest in flexible liquidity pools

New advanced liquidity pools give you greater control and flexibility to help you manage the risk of impermanent loss and maximise profit.

For example, some of the latest liquidity pools allow you to:

1. provide liquidity with more than 2 tokens.
2. add liquidity at a flexible ratio (60:40, 70:30, 80:20, etc).
3. define a specific price range for your liquidity.

With these tools, you can control how much risk of impermanent loss you’re exposed to and maximise your profit.

Impermanent loss FAQs

1. How does impermanent loss happen?

When you provide liquidity to a pool, you are essentially locking in a ratio of two assets.

If the price of one asset goes up and the price of the other asset stays the same, the ratio of your assets will change.

This means that you will have less of the asset that went up in price and more of the asset that stayed the same.

This discrepancy is what causes impermanent loss as your LP token will now be worth less than if you had just held onto the initial tokens amount.

2. Can impermanent loss be recovered?

Yes.

Impermanent loss can be recovered if the price of the tokens returns to their original levels as when you deposited them in the pool.

Or if you wait long enough for the fees earned to offset the impermanent loss.

3. Is impermanent loss always bad?

Impermanent loss is not always bad. It’s just the opportunity cost between holding and liquidity mining.

You can still make a lot of money on your investment even with impermanent loss. It may only reduce your profit.

4. How much impermanent loss can I expect to incur?

The amount of impermanent loss you incur depends on the volatility of the tokens in the pool and their deviation from the 50/50 ratio.

The more volatile the assets and the more the ratio deviates from 50/50, the more impermanent loss you are likely to incur.

Conclusion

Impermanent loss is the most important risk of providing liquidity in DeFi.

In this post, we have discussed everything you need to know about impermanent loss and to manage or completely avoid it.

These include investing in:

1. single token staking or one-sided liquidity pools.
2. high APY pools.
3. stablecoin pools.
4. low-volatility pools.
5. flexible liquidity pools.

Which is your favourite way to manage to avoid impermanent loss?