Understanding Impermanent Loss

If you want to make profits from exploring DeFi, understanding impermanent loss is vital. We’ve summed up the fundamentals from what impermanent loss actually is, how to avoid it, and how the NFTART token has an interesting dynamic in farming due to the tokenomics.

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@enter.artPUBLISHED 5TH JANUARY 2022

 If you've delved into DeFi in any capacity, chances are you've heard this term a time or two. Impermanent loss occurs whenever the price of your token changes from the time it was deposited into the pool. 

You might be asking yourself, "Wait, you're telling me that I can actually LOSE money by providing liquidity?" 

Well, this occurrence is baked right into a design characteristic for a particular market that's known as an automated market maker. Providing liquidity can certainly prove to be profitable, but it's important to keep the concept of impermanent loss in the back of your mind. 

What Is Impermanent Loss, Exactly?

Impermanent loss happens whenever you put forth liquidity into a liquidity pool and the prices of your tokens change from the time they were deposited. The larger the disparity is, the more exposure to impermanent loss you'll experience. In a nutshell, this means your dollar value is lower than it was when you deposited. 

Liquidity pools that have assets that tend to stay in the smaller price brackets generally don't get hit nearly as hard by impermanent loss. So why do the providers still offer options of liquidity if they're exposing themselves to the potential of a financial loss? Impermanent loss can be made up for with trading fees.

For example, Uniswap charges something in the realm of 0.3, 0.4% on every single trade. For some high-volume liquidity pools that have trading transactions going on all of the time, it can be profitable, even if the liquidity pool is exposed to a hefty amount of impermanent loss. This varies from pool to pool, but the market conditions, and assets. It's much more common for impermanent loss to be a net negative for industry beginners. 

How Does Impermanent Loss Occur? 

Before we talk about how impermanent loss happens (and to understand how it happens is how you monitor it), we need to go over how automated market maker (AMM) pricing operates and how arbitrageurs play a part in that process. 

AMMs, in their basic state, are separate from the external markets. This means that the AMM doesn't just change its prices automatically if the external market's prices change. That's where an arbitrageur comes in -- they purchase underpriced assets, or they sell assets that are priced too high, until the AMM prices match that of the external market. 

While this is all happening, the profit is removed from the liquidity providers by the arbitrageurs, and impermanent loss is the result. 

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How Do I Avoid Impermanent Loss?

Now that you have an understanding of what impermanent loss means, how do we prevent it from happening? For many of the liquidity pools out there, it's just a simple fact of life, but there are several strategies you can utilize to severely lessen the effects of impermanent loss, and in some cases, remove the effects altogether. 

1. Liquidity Mining Programs

This is essentially when governance tokens are distributed to their initial liquidity providers. Today, this is seen everywhere within the world of decentralized finance. Not only that, their token rewards regularly make up for whatever impermanent loss you might experience. What's the big deal of losing 6% to impermanent loss if you earn back 20% or even 50% over the course of the next few months due to liquidity mining programs? 

2. Stay Away from Volatile Liquidity Pools 

Liquidity pools that are centralized around assets that are volatile will always be the biggest and riskiest sources of impermanent loss. Small coins, and even chips like WBTC, and ETH can face HUGE price swings, even multiple times throughout the day. It's best to stay far away from these types of pools if you're trying to avoid impermanent loss.

3. Go for Staking Pools That Are One-sided

You don't have to stick with two-token liquidity pools in the world of decentralized finance. Staking pools are a popular way for liquidity pools to gain revenue, which can be used to ensure protocol solvency, and they tend to only take deposits that are one specific type of asset. There won't be impermanent loss in these types of pools, because you won't find any ratio-balancing between assets. 

4. Go For Liquidity Pools That Have Same-pegged Assets

Same-pegged asset liquidity pools have historically shown minuscule amounts of volatility between token pairs. For example, in general stablecoins like DAI and USDC always trade for around $1. 

5. Utilize DeFi Dashboards to Monitor and Track Impermanent Loss

DeFi Dashboards are essentially apps that let you keep tabs on your investments from a centralized dashboard. They can give you real-time updates on your profits or losses, your investments into the different liquidity programs, your lending/borrowing record, and more. Big-name dashboards like WalletNow and DeBank are good ones to help you keep track of your impermanent loss, among other things. 

NFTART Is a Great Option to Mitigate the Cost of Impermanent Loss

NFT means non-fungible token. This essentially means that it's unique and can't be replaced with something else. Bitcoin is a great example of a fungible token -- you can trade one for another, and the net sum is the same. Something like a piece of art, or a unique piece of music, for example, is not a fungible asset. 

NFTs can be pretty much anything that lives in the digital space -- photoshop art, AI, music, drawings, photography, 3D models, etc. There's a lot of buzz in the DeFi world around selling this kind of art. 

NFTART is a deflationary token (10% burn and redistribution on each transaction). This gives for an interesting dynamic when NFTART is the stagnant or falling asset relative to BNB. This is because a part of the NFTART is converted to BNB without any transaction fees, which means that users would save 10% on splitting the pair and another 10% selling the funds that have been converted to BNB because of impermanent loss. This gives a sort of discount on impermanent loss.

You can find the NFTART-BNB Farm on Autoshark. Autoshark is the very first AMM and yield optimization software, which gives you unparalleled access to farming opportunities. 

In Conclusion...

AMMs are rising in popularity, and as that continues, impermanent loss is something that an ever-increasing amount of people are having to deal with. Thankfully, there are a handful of ways to mitigate, eliminate, prevent, or even use impermanent loss to your advantage. 

Hungry for knowledge? Explore more blockchain and DeFi related articles on enter.blog:
https://www.enter.blog/@enter/what-is-blockchain
https://www.enter.blog/@enter/yield-farming-vs-staking
https://www.enter.blog/@enter/how-to-swap-safely

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