What is an impermanent loss in farming?
Impermanent losses occur when the dollar value of the tokens decreases after you deposited them in a liquidity pool.
Impermanent losses arise due to fluctuations in the rate of cryptocurrencies the investor puts into farming on a decentralized exchange. Coins pre-deposited at a 50/50 ratio will tend towards this ratio, which can lead to a decrease in dollar-denominated holdings.
Most DeFi protocols allow users to become market makers for currency pairs. By investing in liquidity, the user receives commissions for trading operations on the platform and part of the rewards from the project or DEX exchange, if any.
"Pool" tab for investing liquidity on Uniswap
Most liquidity pools require funds to be deposited in a 50/50 dollar ratio. If a trader places 1,000 USDT into the ETH / USDT trading pair, he must add the corresponding amount of Ethereum (0.6 ETH as of now). If during farming, the price of ETH falls by 50%, then its dollar equivalent will decrease, and it will end up in the trading pair of $500 Ethereum and $1,000 USDT. The liquidity pool will automatically balance the cryptocurrencies so that their dollar equivalent is the same. In our case, the pool will increase the amount of ETH and decrease the amount of USDT. Based on this, the amount of USDT will be reduced to $750.
What determines the amount of impermanent losses
- Decentralized exchange. The platforms have different types of market makers (Flat Curve, AMM, and others), as well as different networks for work, which affects trading volumes;
- The amount of liquidity in the pool. The larger it is, the less impermanent losses will be for each user;
- Type of coins and their volatility;
- The commissions and rewards on the platform.
A special table shows the ratio of the asset's value to potential impermanent losses. According to it:
■ 1.25x price change = 0.6% loss
■ 1.5x price change = 2% loss
■ 1.75x price change = 3.8% loss
■ 2x price change = 5.7% loss
■ 3x price change = 13.4% loss
■ 4x price change = 20% loss
■ 5x price change = 25.5% loss
The ratio of asset price changes and impermanent losses
This system is applied both to the asset's growth and fall.
Suppose the price of the tokens allocated as liquidity (at the time of withdrawing back to the wallet) returns to its previous figures. In that case, impermanent losses are leveled for the most part, and the losses will be covered by the income from the farming itself.
How to increase farming income
Here are a few tips to help you increase your profits from farming or staking tokens and minimize impermanent losses:
- Choose highly liquid DEXs for work;
- Deposit coins with low volatility. One of the cryptocurrencies should be a stablecoin;
- Add liquidity in batches and try to buy farming tokens at the lowest price.
