<h2>What is impermanent loss?</h2><p class="prosemirror-p-center"><img src="https://cdn.builder.news/news/11ed290be5039ba1a8e6023f659fee92.jpg" alt="What is impermanent loss?" title="What is impermanent loss?" width="600" height="400" class="lykafe0"></p><p dir="ltr">When you lend money to a liquidity pool and the value of the assets you deposited changes from when you deposited them, this is known as an <strong>impermanent loss</strong>. The more significant the change, the greater the risk of impermanent loss. In this instance, the loss represents a reduction in dollar value from the time of deposit to the time of withdrawal.</p><p dir="ltr">Assets in pools that stay within a narrow price range will be less susceptible to impermanent loss. For instance, <a href="https://www.builder.news/crypto-insights/types-of-stablecoins-and-their-role-VEnZL" alt="3 Types Of Stablecoins" title="3 Types Of Stablecoins" target="_blank" rel="" class="">stablecoins</a> or various wrapped coins will maintain a fairly narrow price range. In this scenario, liquidity providers face a lower chance of impermanent loss (LPs).</p><p dir="ltr">In light of their exposure to risk, why do liquidity providers continually offer liquidity? Trading commissions can still be used to offset impermanent loss. In fact, because of the trading fees, even pools on <a href="https://www.builder.news/crypto-insights/all-about-uniswap" alt="Adequate understanding about Uniswap" title="Adequate understanding about Uniswap" target="_blank" rel="" class="">Uniswap</a> that are very susceptible to transient loss can turn a profit.</p><p dir="ltr">Every trade that directly benefits liquidity providers is subject to a 0.3% fee from Uniswap. Even if a pool is substantially exposed to impermanent loss, it may be advantageous to supply liquidity if there is a high trading volume in that pool. However, this is dependent on the protocol, the particular pool, the assets deposited, and even broader market conditions.</p><h2>What causes impermanent loss?</h2><p class="prosemirror-p-center"><img src="https://cdn.builder.news/news/11ed290be503a73aa8e6023f659fee92.jpg" alt="Impermanent Loss explanation" title="Impermanent Loss explanation" width="600" height="337" class="lykafe1"></p><p class="prosemirror-p-center"><em>Losses to liquidity providers due to price variation (Source: Internet)</em></p><p dir="ltr">Investors are likely to place an equal value of each asset in their digital wallets when there is enough liquidity in the pool. The investor will then probably get tokens from liquidity providers. Your deposits are summed up as <strong>a particular portion of the liquidity pool</strong> in this report. It usually fluctuates and relates to the investor's flexibility in providing liquidity relative to the total amount existing in the pool.</p><p dir="ltr">For instance, if an investor contributes $300 worth of assets totaling $2,000, the tokens for the liquidity pool will entitle them to 30% of the pool. When an investor uses them to withdraw their funds at a later time, impermanent loss is probable to happen. On the other hand, if additional investors gradually add their resources to the liquidity pool and contribute up to $3,000, the initial investor would be eligible for profit up to 10% of the total amount.</p><p dir="ltr">To better understand how this occurs in different circumstances, let's look at another example. Let's say Bitcoin's cost reaches 500 BITS. As this occurs, any specific group of arbitrage traders will seize the chance to increase the liquidity pool by incorporating additional cryptocurrency pair pairings. Up until the specified ratio accurately represents the current price, they are likely to keep adding new currencies to the pool. It is crucial to keep in mind at this stage that the price is determined by the ratio of assets in the pool. The degree of the relationship between cryptos can only be determined by this one important component. If the price drops to $400, the actions of arbitrage traders will determine how much Bitcoin and how much a unit in the pool have changed.</p><p dir="ltr">Now, if an investor wishes to withdraw their money, they will need to secure a specific amount of money in order to maintain their share of the earnings while taking into account the original cost of their token deposit.</p><p><em><strong>&gt;&gt;&gt; Related article:</strong></em>&nbsp;<a href="https://www.builder.news/crypto-insights/an-ultimate-guide-on-automated-market-makers-PvtRU" alt="An ultimate guide on Automated Market Makers" title="An ultimate guide on Automated Market Makers" target="_blank" rel="" class=""><em><strong>An ultimate guide on Automated Market Makers</strong></em></a></p><h2>How to estimate impermanent loss?</h2><p dir="ltr">Because <strong>impermanent loss is dependent on sheet value</strong>, it is subject to change until a decision is made. If you choose to withdraw following a price fluctuation, your loss will be irreversible.</p><p dir="ltr">Things start to become fascinating at this point since the figure you receive will be very different from what you had anticipated. Arbitrage traders can pounce and purchase the token for a discount when the price of ETH rises.</p><p dir="ltr">Traders can substitute Ethereum and add DAI until the ratio reflects the new rate since the new price for ETH is 200 DAI and the previous price in the liquidity pool is 100. This ratio is calculated using a complex formula, but you can find the precise value online using a calculator.</p><p dir="ltr">Keep bear mind that your pool has 1000 DAI and 10 ETH. We now obtain a new ratio by entering the new ETH price of 200 DAI into the calculator.</p><p class="prosemirror-p-center"><strong>10 ETH/1000 DAI ⇒ 7.07 ETH/1,414.21 DAI</strong></p><p dir="ltr">As you can see, the traders that engaged in arbitrage profited by exchanging 2.93 ETH for 414 DAI. However, you continue to have a 10% share of the new ratio. If you withdraw, you'd get 0.707 ETH times 200 and 141.421 DAI, which comes out to $282.</p><p dir="ltr">Although this is still more than the $200 you began with, you would have had $300 if you had not deposited.</p><iframe width="560" height="315" src="https://www.youtube.com/embed/HPGSSkOq0-Q" frameborder="0" allowfullscreen=""></iframe><p class="prosemirror-p-center"><em>Impermanent Loss explanation (Source: Binance Academy)</em></p><h2>Ways to prevent impermanent loss</h2><p dir="ltr">When an investor uses their stake in a liquidity pool, an impermanent loss is a common occurrence for a particular market that is volatile. Regardless of these elements, cryptocurrency exchange values are continually in flux. Many people become proficient with these techniques as they master the <a href="https://www.builder.news/crypto-insights/metrics-in-defi-v3cNi" alt="How to understand and use the metrics in DeFi" title="How to understand and use the metrics in DeFi" target="_blank" rel="" class="">fundamentals of Defi</a>. However, there are a number of other approaches that can effectively stop impermanent loss. Here below are some of the <strong>ways to avoid impermanent loss</strong>:</p><h3>Introducing trading fees</h3><p dir="ltr">It is crucial to make sure that a particular percentage of trading costs is included in the liquidity pool for any given instance of impermanent loss. Trading commissions are a fee taken from the traders who provide the liquidity pool.&nbsp;</p><p dir="ltr">To help with effective management, a portion of the total fees is handed to the liquidity providers after being collected from the traders. This sum is frequently sufficient to cover any impermanent loss in the liquidity pool. There will be less impermanent loss if more trading fees are received. Once the chain is started, a pool will eventually become available with sufficient fees. This sum would be comparable to the ownership percentage of an investor's assets in a liquidity pool.</p><h3>Maintaining low volatility</h3><p dir="ltr">If we observe, impermanent loss typically occurs in cryptocurrency transactions that are done voluntarily. By selecting a pair of cryptocurrencies with less erratic exchange rates, any given situation of impermanent loss can be managed. DAI and USDT are a few examples of cryptocurrency pairs with less volatile characteristics.&nbsp;</p><p dir="ltr">Other similar cryptocurrency pairs may have various iterations of the same token. It is crucial to make sure that certain coin pairings follow approximately the same price. The need to monitor and take note of price changes between the specified cryptocurrency pair is a crucial requirement.&nbsp;</p><p dir="ltr">On the other hand, if the price fluctuation of a particular cryptocurrency does not already exist, the impermanent loss can be prevented to a higher extent. Therefore, keeping low volatility among cryptocurrency peers may be the key to experiencing little to no impermanent loss.</p><h3>Complexity in liquidated pools</h3><p dir="ltr">In any liquidated pool, impermanent loss might occur for a variety of causes. Among them, the presence of complexity in liquidity pools is one of the most well-known and frequent factors. Since most liquidity pools require an equal split, it frequently occurs. Several decentralized exchanges adopt and use a range of liquidity pool ratios to neutralize the overall effect in order to overcome this difficulty. The Balancer offer is one illustration of a decentralized exchange that makes use of this technique. They provide liquidity pools that include various digital assets. When considering the behavior of cryptocurrency ratios, price changes typically have a greater ratio that forbids impermanent loss. Compared to liquidity pools with a half split, it is far less.</p><h3>Single-sided liquidity pools</h3><p dir="ltr">Two distinct cryptocurrency currencies being put in a single common liquidity pool is one of the ideal situations for impermanent loss to occur. Even though some decentralized exchanges now offer liquidity pools with the option to stake only one side, the user is still unable to access the other side of the liquidity pool. One such exchange that provides the depositor with a chance to add an equivalent amount of value to the system is Bancor. Because a user only needs to grant access to one side of the liquidity pool in such circumstances, there is no risk or potential for any impermanent loss. The decentralized oracle serves as the price feed for the decentralized exchanges. This makes it possible for the liquidity pool to automatically adapt whenever there is a major change in pricing.</p><div class="pr-block-special"><strong>Disclaimer:</strong><br>This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.</div>

Anyone involved in DeFi should be aware of impermanent loss in order to reduce the risks associated with investments. So, what precisely is impermanent loss and how could people prevent it?

Impermanent loss - Sounds familiar but odd?