Impermanent loss
If you provide liquidity to a pool and the price of your deposited assets change over time, you incur an impermanent loss. The more it changes, the greater the risk of impermanent loss. As a matter of fact, impermanent losses should be temporary, provided that the trading fees you earn from providing liquidity compensate for the losses
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 their 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 goes outside of this range, Lancelot will hold either all ETH or USDC, which could result in impermanent loss if the price comes back to his range
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
Galahad provides liquidity for the token pair with a range of $800-$1200 (ETH-USDC)
If the price goes up to $1600, Galahad will hold only ETH
If the price later drops to $1000, Galahad would have an impermanent loss because he had less exposure to USDC 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
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
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
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