What's Impermanent Loss and How to Avoid It

What is Impermanent Loss?

Impermanent Loss refers to the temporary loss in Automated Market Making (AMM) caused by market fluctuation when a Liquidity Provider (LP) injects liquidity into a liquidity pool. According to the "Constant Product Market Maker" pricing model, when an LP removes liquidity during the market fluctuation, the value of his assets decreases compared to simply holding the tokens. This is what we call impermanent loss. However, impermanent loss will gradually be wiped out when the price ratio changes back.

Example for Impermanent Loss

1. Assuming that currently there are 1 000 CET and 500 USDT in the liquidity pool, the constant product is 1 000 * 500 = 500 000. The liquidity Provider(LP) Adam holds 10% of the assets in the CET/USDT pool, that is, 100 CET and 50 USDT. At this time, 1 CET = 0.5 USDT.

2. Suppose that after a period of time, the CET price rises, and the amount of the pool tokens has changed into 500 CET and 1 000 USDT. The constant product 500 * 1 000 = 500 000 remains the same, but at this time, 1 CET = 2 USDT. LP Adam's holdings in the pool also change accordingly, becoming 50 CET and 100 USDT.

3. Assuming that LP Adam removes liquidity when the pool contains 500 CET and 1 000 USDT, since he has a 10% share, in total he can remove 50 CET and 100 USDT. After removing liquidity, the value of his assets is 50 * 2 + 100 = 200 USDT.

4. At the time of adding liquidity, Adam owned 100 CET and 50 USDT. If he simply held the tokens and did not invest in the liquidity pool, the total asset value would be 100 * 2 + 50 = 250 USDT. However, after removing liquidity, he only gets 200 USDT. The difference in value between adding liquidity and simply holding the assets is the impermanent loss. In Adam‘s case, the loss is 50 USDT.

Note: To simplify the calculation, the trading fee is not considered in the above example.

Impermanent Loss Estimation

Here’s a chart of estimated Impermanent Loss for your reference:

How to Avoid Impermanent Loss?