Imagine if you invested into a coin that was worth $100. You buy one. You lend that coin to a platform like AAVE that gives you interest on that coin. For the purposes of this video, let’s assume they give you 10% return on average a year. So at the end of the year you should have 1.1 coins worth $110, right? Nope, because that coin’s price dropped by half, and now you still have 1.1 coins, but they are only worth $55. Unfortunately, you earned interest, but the overall value of your investment plummeted.
In this article, we are going to explain how to avoid impermanent loss.
First off, if you’re new here, let’s go over a review of what impermanent loss is.
What is impermanent loss?
Impermanent loss is a very difficult concept to understand for beginners. If you do not fully understand the idea, you definitely need to watch our specific video where we explain it using simple terms and a few examples. In short though, Impermanent loss happens when your investment loses money due to how liquidity pools work.
You provide 2 coins to a liquidity pool. By giving them your coins, you are allowing traders to trade back and forth using your 2 tokens. Due to this, these traders pay you fees… in fact there are usually a lot of other investors with you and all the investors split the fees evenly based on their portion of the funds they contributed.
Impermanent loss is the temporary loss of value you experience when the 2 tokens you invested in change in value relative to each other. Put simply, if one goes up and one goes down… you will have IL. If one goes up and the other stays the same, you will have IL. And if one goes down and the other stays the same, you will have IL.
You want them to stay roughly the same price or both to go up if you intend to make money.
So, without further ado, let’s get into the 6 ways to avoid Impermanent loss.
1) Provide to stablecoin pairs
Since stablecoins don’t really move in price, they are theoretically immune to impermanent loss. Because of this, many other investors have already maxed out these pools so they give very small rewards. It should be noted that investing in two stablecoins is probably the safest way to provide liquidity. You’ll have to watch out for any stablecoins that might collapse. For example, recently Iron Finance created a stablecoin that was giving out ridiculous rates for providing liquidity, and overnight the price of that so-called stablecoin dropped to 0. There are also many rumors that Tether is overleveraged and printing too many Tether tokens, which can cause them to become unpegged to $1 – in fact, we have a whole video over tether for you to check out. So even though it’s quote “the safest” way, you are still exposed to risks.
2) Avoid risky or volatile coins
Speaking of risk, #2 is to avoid risky or volatile coins. Impermanent loss is maximized when a coin is volatile. Since stablecoins rarely move in price, the impermanent loss is minimized, however this works the other way. When a coin quickly changes price up or down, you will also experience quite a bit of impermanent loss. Many tokens that are new are quite volatile, and also tokens that have low liquidity are quite volatile. In the same category, new and low liquidity tokens also seem to be more risky. Tip #2 is to avoid these coins, because even though they are high risk, they are high reward.
3) Provide when a coin price is low
If you’re just trying to make sure your impermanent loss isn’t affected by the coin going down, you can attempt to provide liquidity during a bear market. This way you will earn a reward for providing liquidity, while also gaining some price appreciation from the coins you are providing to. Even though you are going to experience an impermanent loss, you’d rather experience it with your total value still going up, as opposed to the value going down.
4) Provide to places that offer extra incentives
There is a decentralized exchange called Dfyn. Currently, they are offering extra rewards for staking your LP tokens, these rewards are commonly referred to as “Liquidity Mining Rewards”. In short, you automatically earn rewards for providing liquidity from the fees that traders pay. For example, one stablecoin pair is offering a 5% return right now. However, the platform is also giving you their own native Dfyn tokens for staking that liquidity. Right now, there is another 55% APR for people that stake their LP tokens. That means you just have to lock it up and not do anything with your LP tokens and they’ll pay you. It’s important to know you’re earning Dfyn, and Dfyn is a very new platform, so the token price could go to zero, meaning your rewards are speculative. Many investors advise trading a certain portion of those Dfyn tokens for other tokens like ETH or USDC if you’re unsure of the project but still want to provide liquidity and earn an incentive. If you add the LP fees with the extra incentive of those liquidity mining fees, this is a 60% APR for providing stablecoins, which have almost 0 impermanent loss if they stay pegged to $1.
5) Provide to a pool that isn’t 50/50
Usually, when you provide to a liquidity pool, the ratio of tokens is 50/50, meaning 50% is one token, and 50% is the other token. This means there is an equal share of both tokens, and theoretically an equal risk.
However, there are platforms that change this weight, or ratio, so that the risk is less.
For example, a platform called Balancer lets you do pairs like 80/20 and even 98/2. These pairs allow you to provide liquidity with a different probability for Impermanent Loss to happen to the portion of the pool that is smaller or larger.
Another platform called Bancor actually automatically adjusts weights. This means as time goes on, they may go from 50/50 to 60/40 or 70/30. At the current moment in time, we actually have not done much research on the effects of this long-term, but if you leave a comment below about wanting a video on Bancor, it’ll let us know there are people interested in the topic and we’ll do the nitty gritty research for you.
In short, changing your ratio in the pool from 50/50 to another ratio can mitigate your risk of Impermanent Loss if done correctly.
6) Provide to a pool that isn’t just 2 assets
There are also liquidity pools out there that have more than 2 assets, some up to 8 and even higher. The math performed so these pools work out is quite complicated and out of the scope for this simple video, but our job is to educate you on the ways to avoid impermanent loss, and this is simply one of the tools in the book.
Now that we are at the end of this video, we wanted to give a shoutout to our website WhiteboardCrypto.com. Unlike videos, the articles on our website can always be improved, we can add images, and include more up to date material. For this reason, we suggest you to check out our website, specifically our page on this topic in the link below, especially if you are watching this in the future, as we plan to add more ways to avoid impermanent loss as we learn about them.
Thanks so much for reading this article, feel free to leave a comment blow, it helps us grow. We hope you enjoyed this article, we really hope you learned something, and most importantly, we hope to see you in our next article!