Understanding Impermanent Loss

At its core, impermanent loss is the difference in potential earnings between holding tokens in an AMM and simply holding them in your wallet. Impermanent loss occurs when the price of tokens inside a pool deviates from when they were initially deposited. If the prices return to their initial state, the loss is impermanent since the value returns to its original state. Although, if the prices remain diverged, the loss becomes permanent.

Though such losses can be offset by trading fees earned from liquidity provision, a clear understanding of impermanent loss dynamics remains crucial.

For a comprehensive understanding of IL, consider reading this detailed article

How to avoid Impermanent Loss?

  • Impermanent loss occurs when there is a significant price difference between the assets in the liquidity pool. Therefore, you should consider the historical price movement and volatility of the assets before providing liquidity. If the assets are known to have high volatility or price fluctuations, you may want to choose a wider price range to reduce the risk of impermanent loss (Applies only to V3)

  • Use correlation analysis to determine the relationship between the assets you're providing liquidity for: - If the assets are highly correlated, it may reduce the risk of impermanent loss - If the assets have a low correlation, it may increase the risk of impermanent loss

  • Liquidity pool size and trading volume can affect the risk of impermanent loss. Generally, larger liquidity pools and higher trading volumes can reduce the risk of impermanent loss. You can use analytics page to analyze historical trading volumes and liquidity pool size to determine the best liquidity pools to provide liquidity for

  • Impermanent loss is an ongoing risk, and you should monitor your liquidity pools regularly to adjust your strategy as necessary. This may involve rebalancing your liquidity, adjusting your price ranges, or withdrawing liquidity altogether

Understanding Impermanent Loss in V3

  • Because the concentrated liquidity model allows LPs to provide liquidity at specific price points, they may be exposed to more risk from price volatility than in V2

  • If the price of the assets being provided liquidity for moves outside of the price range where liquidity is concentrated, LPs may face more significant losses

  • An impermanent loss is realized if the deposited assets change in price since the deposit

  • There is no impermanent loss if the price returns to its initial level

  • If you remove your funds from the liquidity pool before the price returns to its original level, the impermanent loss will become permanent

Example A: Narrow range

  • Lancelot provides liquidity for a token pair (ETH and USDC) with a range of $1000-$1500

  • As long as the price stays within $1000-$1500, Lancelot earns fees from trades

  • If the price of the assets being provided liquidity for moves outside of the price range where liquidity is concentrated, Lancelot's LP may face more significant losses

Example B: Wide range

  • Robin provides liquidity for the same token pair with a range of $500-$2500

  • Robin's range is larger, so he earns fees from a wider price movement, but his money works less efficiently

  • If the price stays within $500-$2500, Robin will have a smaller chance of experiencing impermanent loss compared to Lancelot's small range

Example C: Out of Range (Manual mode)

  • Galahad provides liquidity for the token pair with a range of $800-$1200 (ETH-USDC)

  • If the price goes up to $1200, Galahad will hold only USDC

  • If the price later drops to $1000, Galahad would have an impermanent loss because he had less exposure to ETH when the price was within his range

In simpler terms, impermanent loss when providing liquidity to V3 depends on the price range you choose and how the asset's price changes. By picking a wider range, you can reduce the chance of impermanent loss, but you may also earn less from trading fees

Example D: (Auto mode - Gamma)

Does the single-sided liquidity provision in V3 eliminate the risk of impermanent loss?

While it does help reduce the impact of impermanent loss, it doesn't completely eliminate the possibility of risk. Providing liquidity still carries certain risks, including price volatility and fluctuations in the market

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