What Is Impermanent Loss?
News | June 29, 2021, 16:38 PM | The content is supplied by a Guest author
Cryptocurrencies are getting more popular, and many people think about investing some money in them. It is possible to mine crypto coins if you have enough resources; otherwise, you can join a mining pool. When it comes to investing money in crypto coins, it is essential to mind possible risks. In particular, traders need to have an understanding of what impermanent loss is. Read this article to learn about that.
Important Notions to Know
Before we dig deeper, it is essential to understand a few important terms. The first one is automated market makers (AMMs). Thanks to them, it is possible to trade coins automatically, without the permission of the owner. The thing is that when trades are made on traditional markets, sellers publish their offers, specifying the value of coins available for sale at a certain price. If a buyer thinks that the offer is interesting, one makes a deal.
Demand for cryptocurrencies can change in different directions. When it is too high, and there are not enough offers from sellers, deals cannot be made. This is where we get to another important term liquidity pools. They help facilitate trades on decentralized exchanges. Liquidity providers (LPs) add their crypto coins to such pools. This increases the liquidity of the protocol. Providers get fees if the trade occurs.
Everyone can become a market maker. All you need is to get some crypto coins that you can add to a liquidity pool. The fee is determined by the protocol. It can be 0.3% or less to attract more liquidity providers. Everything seems to be clear; however, there may be pitfalls. In particular, it is an impermanent loss. So, let’s find out what it is.
If you add your coins to a liquidity crypto pool, you should be ready to face impermanent loss. This situation occurs if the price of assets changes. The greater the difference in the price, the larger the impermanent loss will be. Such a loss is called “impermanent” since it is possible to get back to the initial price over time. In this case, the provider will experience no losses and will get the fee back in full.
How to Prevent Impermanent Loss
Unfortunately, no way allows you to prevent impermanent loss. However, it is possible to do something about that. In particular, you can try to decrease your losses. Check out a few simple recommendations on that.
Use Stablecoin Pairs. Everyone who wishes to avoid impermanent loss should consider providing liquidity in stablecoin pairs. That is because the price for such coins is relatively stable. Generally, using such coins is less risky. However, they are not the best option for getting a great income.
Avoid using pairs with high volatility. It is possible to check the history of crypto coins to see how quickly and drastically their price changed over time. Picking crypto coins with lower volatility would be a good choice.
Analyze the market. High volatility is typical for all cryptocurrency markets; so, you can expect that the price may change from time to time. However, as a liquidity provider, monitor the market to be ready to withdraw your crypto coins when the right time comes.
Becoming a liquidity provider is not a difficult thing. Simply purchase some coins and then add them to the pool. Follow simple recommendations provided above to decrease the risk of impermanent loss. For a start, do not add lots of funds to earn some fee. You should start with a small amount of crypto money, which will allow understanding how impermanent loss looks like, how quickly the price can get back, and what can be done to avoid unpleasant consequences.