Understanding Impermanent Loss
Last updated
Last updated
What Is Impermanent Loss (IL)?
Impermanent Loss (IL) occurs when the value of your assets in a liquidity pool changes compared to simply holding them in your wallet. This happens because of price movements between the paired tokens in the pool. While liquidity provision generates fees and rewards, the divergence in token prices can lead to lower returns than expected – this is the impermanent loss.
The term “impermanent” is used because the loss isn’t realized until you withdraw your liquidity. If prices realign to their original ratio, the loss can disappear. However, this also means that if you withdraw at an unfavorable price ratio, the loss becomes permanent.
RULE 1: IL is fixed only once position is closed
Your overall PnL in liquidity provision consists of 3 components:
Trading Fees Earned: Rewards from providing liquidity.
Token Price Movement: The appreciation or depreciation of the tokens in your position.
Impermanent Loss: The reduction in value due to price divergence between tokens in the pool.
When users focus only on fees earned and token appreciation, they often overlook the IL component. This can make the position appear profitable when, in fact, the net returns are lower due to IL.
RULE 2: Liquidity Farming has non-linear PnL
In DeFiTuna, positions operate within a specific price range. Here’s what that means:
A long position benefits from token appreciation but only within the active range. Once the price exits the range, the position effectively “freezes.” No new fees are earned, and the unrealized IL is locked in.
A short position works the opposite way but is similarly constrained by its range.
Many users mistakenly believe they are making money as token prices move favorably within the range. However, if the price moves out of range, the position stops earning, and any gains could be eroded by IL upon exit.
RULE 3: Out-of range positions brings nothing but IL
Amplification of Exposure: Leverage magnifies both gains and losses. In the context of liquidity provision, this means that any price movement between the paired tokens has a multiplied effect on your position. If the tokens diverge in price, the impermanent loss is amplified in proportion to the leverage.
Higher Borrowing Costs: Leveraged positions typically involve borrowing assets, which adds to your overall costs. If the IL is already reducing your returns, the additional borrowing costs can turn a seemingly profitable position into a loss.
Margin Pressure: In leveraged setups, IL can reduce your position's value to the point where margin requirements are no longer met. This could lead to forced liquidation, turning unrealized losses into realized ones.
RULE 4: Leverage amplifies your IL
Choose Wider Ranges for Stability: A wider range reduces the sensitivity to price movements and mitigates IL, though it may lower your fee earnings.
Use Conservative Leverage: Lower leverage minimizes the amplification of IL and gives you more room to manage your position without being forced to close.
Monitor Constantly: With both leverage and narrow ranges, continuous monitoring is essential to avoid adverse outcomes.
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