What is impermanent loss? Impermanent loss is the unrealized loss that occurs when the share of a liquidity provider position becomes uneven compared to its original position. Impermanent loss only happens to people who provide liquidity to a liquidity pool.
Let us say you put up 100 Ethereum and $ 10,000 into a liquidity pool. Now, most liquidity pools want there to be a 50:50 ratio whenever you initially start your deposit. Therefore, we can reasonably assume the price of one Ethereum at this point is $ 100. So, there is $ 10,000 worth of a stable coin and $ 10,000 worth of Ethereum that you are putting into this liquidity pool. So you take that total of $ 20,000 and put it into the liquidity pool, hoping to profit from some of the fees that will happen within the pool time. For our first example, let us say that the price of Ethereum rises to $ 110. Well, a trader can come along and realize that he can buy Ethereum at your liquidity pool for $ 100 and then sell it to CoinBase for $ 110. So, he keeps buying more and more and the algorithm will keep charging him more and more until he stops making money. That is how these decentralized exchanges work. You pay more and more for each asset that you want to buy so that way it never runs out of the asset to sell you even if it gets down to very little. The price will start to go up exponentially. However, in our case, the asset was much cheaper than another exchange so it created what we call an arbitrage opportunity for a trader. If we do the math we figure out that he was able to give $ 488 and buy 4.652 Ethereum at least until the liquidity pool price was also $ 110. If he bought any more Ethereum he would be losing money so he immediately sold his cheaper Ethereum that he bought from us to CoinBase for $ 511.82 which means he made a profit of $ 23.82 simply by buying and selling between two different liquidity pools.
Now let’s take the stance of being that liquidity provider. This means there are now $ 10,488 of the stable coin in the pool and 95.347 Ethereum in the pool. So if we take 95.347 and multiply it by $ 110 because that’s the going price of Ethereum we get $ 10,488. So if we take $ 10,488 of our stable coin and $10,488 of our Ethereum and add them together we get a total value of $ 20,976. So the liquidity provider now has a total value of $ 20,976, meaning he made a nice $ 976. Because Ethereum went up, he made some pretty decent money today.
However to calculate impermanent loss we need to calculate how much money he would have had if he didn’t invest in the liquidity pool and just held his stable coin and Ethereum in his wallet instead. So obviously, he still would have had his initial $ 10,000 but what about if he held his 100 Ethereum? Well now that 100 Ethereum would be worth $ 11,000. So he would have had a total of $ 21,000 if he just held it. This means we can calculate his impermanent loss to be $ 21,000 minus $ 20 976 which is $ 24. So in short, this liquidity provider would have made more money if he just held on to his Ethereum and stable coin. Now, $ 24 might not seem like much but imagine a similar scenario where the price jumps 20% instead of 10 % or the price dropped by half. In short impermanent loss is caused when the difference between two assets in a pool is changed. As this change increases, so does the impermanent loss. So if Ethereum goes back to a $ 100, then the impermanent loss is canceled and there’s no one permanent loss because both assets would be the same as when the liquidity provider initially invested them. They call it an impermanent loss because it only becomes permanent whenever you cash out your liquidity until you do that there is still an opportunity for the loss to normal itself out. So to sum it up, an impermanent loss is the loss that you get when you have less money by investing in a liquidity pool compared to the value of the assets that you would have had if you just held them.
Essentially, what you need to know is that it’s good for any liquidity provider when two assets that you are investing in stay roughly the same price. When one goes up and the other stays the same the liquidity provider starts to experience impermanent loss and can only recover from that loss if the first asset starts to come down to equal out the liquidity. Now it gets tricky when both asset prices start moving. In short, if they go in opposite directions, the liquidity provider starts to lose money very quickly. However if they increase at the same rate or decrease at the same rate, the liquidity provider may not lose money due to impermanent loss at all and they may just reap the rewards of the profits from the trading fees. If we have a neat little chart to look at to see how much impermanent loss a liquidity provider may experience in terms of how much that asset changes in price as a price of an asset increases past 100 percent of its value to the other asset. The impermanent loss grows and as the price of an asset decreases less than 100 percent the impermanent loss also grows so like I mentioned we want the price to be about the same as when we invested otherwise we start to experience some permanent loss.