Hey crypto friend… want to know how to deal with “impermanent loss”?
What even is impermanent loss?
And what does it mean for my crypto investments … and my liquidity pools?
No worries, Andy Howard here, and I’ve got your back in this post all about that pesky impermanent loss.
While dealing with impermanent loss is nothing to worry about — because we have ways to manage it, which I’ll share with you — it is a risk with liquidity pools that you need to be aware of.
Now then, no time to waste!
Let’s talk about how to deal with impermanent loss.
What is impermanent loss?
So, as I said, impermanent loss is a risk associated with liquidity pools.
Impermanent loss happens when you add two tokens to a liquidity pool, and the price of your deposited tokens ends up changing from when you deposited them.
In other words, your token falls in value after you deposit it in a liquidity pool, exposing you to impermanent loss.
It means the dollar value of your token at the time of withdrawal is less than the amount you deposited.
Again, this is no cause for major concern. Because I’m going to talk about how to deal with impermanent loss.
Illustrating how impermanent loss works
We’re gonna add some numbers and details in a realistic yet hypothetical example to really demonstrate how impermanent loss works.
Let’s say we’re participating in a liquidity pool on Uniswap v3:
- Ethereum (ETH) / Injective (INJ)
- We deposit $27,000 worth of “principal” — aka $27,000 worth of the 2 tokens
- We chose a price range
Now let’s add even more details for this illustration…
When we create this position, the price is on the higher end of our range — so the principal we’re asked to deposit consists of 80% ETH and 20% INJ
We’re ok with this because we expect INJ to outperform ETH in the short- to medium-term time horizon.
And for this example, we’ll say that’s exactly what happened: INJ outperformed ETH, which causes the price of ETH to fall, relative to INJ, and move down within our chosen range.
And fluctuations in price within the range alter the composition of the investment, right?
So, if the price would have been in the dead center of our range when we created the position, we would have been asked to put in 50% INJ and 50% ETH.
Where the current price is, relative to your range, determines how much of each coin you’ll be asked to put into the pool.
Again, as price fluctuates within your range, the makeup of your principal changes.
Now then, since we created our position, there’s been a shift in asset demand: INJ has been the stronger asset — there’s been more demand for INJ than ETH from this liquidity pool.
That means folks like us hopped on Uniswap — our decentralized cryptocurrency exchange of choice — and bought a lot of INJ. They’ve swapped more INJ (the more desired asset) out of the pool… and in exchange, they’ve put more ETH (the lesser desired asset) into the pool.
As that’s happened, the makeup of our principal shifted from 80/20 to 47/53.
While you’re active in a pool, your “principal” is always going to shift in the direction of the lesser desired asset. When users withdraw the more desired asset, the proportion of the lesser desired one increases.
For this example, despite the composition change, it all netted out to be a tremendous positive just 3 weeks later.
How?
Because both of these assets have grown in price relative to the dollar (aka appreciation) since we created our position. So, our principal value has grown from $27,000 to almost $30,000…
And on top of that, we’ve earned fee income of an additional $2,100.
So combined, it’s been a $5,000 return in just a few weeks!
Ideal asset oscillation
Ideally, we want the greater AND lesser desired asset to oscillate back and forth within our defined range for several months or even years.
Why?
Because oscillation creates consistent passive income without manual adjustments.
In other words, INJ is the stronger asset for a couple weeks, then it’s ETH, and then it’s INJ again. The price continues to move back and forth within our range, throwing off passive income for several months (or years) without us having to make any adjustments.
Cool, but what happens if INJ continues to outperform ETH?
Well, what happens is eventually, we’ll be out of range and our principal position will consist of 100% Ethereum and 0% Injective.
Or, if ETH turns around and starts heavily outperforming INJ… we’ll be out of range again, and our principal position will consist of 100% INJ and 0% ETH.
This condition — where your principal consists of 100% of one asset and 0% of the other — is impermanent loss.
And on Uniswap, when you find yourself in impermanent loss (or “out of range”), you stop earning fees as a liquidity provider.
How are we dealing with impermanent loss?
Ok, so the idea of moving out of range and being entirely in one coin… that’s known as “impermanent loss.”
If price moves out of range to the upside and our position is 100% INJ, we’ll experience “impermanent loss” of our Ethereum.
It’s “impermanent” because price can always move back into range, at which point your fee income starts up again and the makeup of your principal starts shifting again (away from INJ and back to ETH).
IMPT: “Impermanent” loss only becomes “permanent” if you close your liquidity position.
Here’s a great tip on how to deal with impermanent loss: set wider ranges for liquidity pools. Doing that ensures ample buffer room for price fluctuations.
Another way to deal with impermanent loss is choosing coins wisely and strategically.
We want to choose 2 coins that have correlated price action because that helps reduce our risk of impermanent loss.
Why?
Because if the broader crypto market is doing well, our 2 coins are both doing well together… and if the broader crypto market is experiencing a dip, our 2 coins are likely both dipping together.
They’re staying closely correlated, relative to each other, which is what allows us to stay in range for a longer period of time.
Now can you see how we’re able to manage and deal with impermeant loss?
Pro Tip: The concept of impermanent loss is why it’s important for us to only participate in liquidity pools with coins that we believe in long term.
Some of my personal choices for dealing with impermanent loss
For me personally, Ethereum and Injective are 2 of my highest conviction coins over the next several years. I’m planning to hold these coins with the belief in their future appreciation.
And, as I’m earning fee income, I’m earning it in the form of INJ and ETH.
Now, any fee income I earn, I can always sell back into U.S. dollars and move it to my bank account if I want.
But! Personally, I don’t, because I’m using liquidity pools to accumulate these 2 coins that I love and strongly believe are going to appreciate in value over the next couple years. So my preference is to accumulate these assets instead of converting them to USD.
And if I experience impermanent loss of one or the other (with my principal), it’s ok because, ultimately, I believe in both, and it doesn’t matter too much which of the two I’m holding.
Look, dealing with impermanent loss just comes with the territory with liquidity pools.
So, keep in mind the impermanent loss reality:
- We must accept impermanent loss as part of the process.
- We must acknowledge that impermanent loss may occur due to market fluctuations.
- We must have belief in the long-term appreciation of the coins we choose.
Using all the guidelines I’ve shared about how to deal with impermanent loss, if the dollar value of your principal dips for a little while or you move into impermanent loss… there’s no reason to panic or feel emotional about it.
What to do if you’re in impermanent loss
If you’re out of range and in a state of impermanent loss…
Option #1: do nothing
Just wait until the market moves back into range.
Option #2: close your position
Remove your liquidity, collect your fee income, reassess things, determine a new range, and then open a new position.
The choice is yours.
That’s a wrap on how to deal with impermanent loss
Now that we know what impermanent loss is and how to manage it. Let’s do a quick recap…
Impermanent loss is when coin pairs move out of range resulting in principal being entirely in 1 coin temporarily…
And that’s why we set wider ranges for liquidity pools, to ensure there’s room for prices to fluctuate. And why we choose 2 coins for each pool that are closely correlated.
Rather than make emotional decisions, slow down and play the long game.
Now then, no need to fear impermanent loss since you know how to deal with impermanent loss like a pro.
Maybe it’s time for you to dive into a liquidity pool or two.
