Impermanent Loss in Yield Farming: 5 Things to Know
Impermanent loss in yield farming is one of the most important concerns of almost all yield farmers. Because of the automated market maker model that governs the liquidity pool where investors lock their crypto-based assets, impermanent loss becomes close to inevitable. So, how can investors protect their money? What is it about the automated market maker model that leads to impermanent losses in yield farming? In this article, we have covered everything that you would like to know about impermanent losses and how to avoid them.
1. What is Impermanent Loss in Yield Farming?
Impermanent losses are the changes in the price of the tokens that you have deposited in the yield farming protocol, starting from the moment when you deposited the funds till the time when you will withdraw them from the liquidity pool. If the difference between the initial price and the final price is too wide, the impermanent losses are more. On the other hand, if the changes are minimal, so are the impermanent losses.
2. What Causes Impermanent Loss in Yield Farming?
The main cause of impermanent loss in yield farming is market volatility. As we know that the crypto market is highly volatile, there are changes in the prices of the crypto assets locked in the liquidity pool. The automated market maker model doesn’t reflect the price changes of the tokens immediately. Instead of this, there is a very narrow time gap between the moment when the price changes on the exchanges and the moment they are reflected in the liquidity pool.
Therefore, when the price of one token out of the equivalent pair increases, the arbitrage traders begin pulling out the first token and add the other one to the pool to maintain the liquidity. This is done before the price change reflects in the pool. Now, the ratio between the tokens changes. So, when the investors try to pull their funds out, they bear impermanent losses.
3. How to Estimate Impermanent Loss in Yield Farming?
Impermanent losses are inevitable in yield farming. No matter in what direction the price of your assets moves, you will have to incur some losses. It is because the yield farming protocol uses an automated market maker model. This means that the lending and borrowing of assets takes place with the help of automatic smart contracts, instead of any third-party agents. The use of smart contracts makes the process much more transparent, cost-effective, and quick.
Since you now know that you will have to suffer some impermanent losses while yield farming your crypto-assets, let’s understand how you can estimate the amount of impermanent loss in yield farming with the help of an example.
Let’s say we are locking a pair of ETH and USDC in the liquidity pool. So, there can be two cases for price change, one is when the price of ETH increases, and the second is when the price of ETH decreases. Here’s how the impermanent loss will change with respect to the % increase or decrease in the price of ETH.
When the % change is positive, that is, the price of ETH increases.
|% Increase in ETH||% of Impermanent Loss|
When the % change in ETH price is negative, that is, the price decreases.
|% Decrease in ETH||% of Impermanent Loss|
4. How to Calculate Impermanent Loss in Yield Farming?
You can calculate the impermanent loss in yield farming by applying the formula given below.
Here, k is equal to the ratio from the initial price of the tokens to the future price of the token. For instance, if the value of the token has increased by 20%, the value of k will be equal to 1.2. Once you find the value of impermanent loss from the formula given above, you can multiply the result with the initial value of the tokens to find the value of impermanent loss you will have to incur.
5. How to Avoid Impermanent Loss in Yield Farming?
While you can not completely escape bearing impermanent losses in yield farming, you can, however, minimize them. So, here are five ways in which you can avoid high impermanent losses in yield farming.
- The investors can lock stablecoins in the liquidity pool. Stablecoins are special crypto coins that do not face very huge price changes as compared to other coins in the crypto market.
- Choose the yield farming platform that offers high transaction fee revenue. This is to make sure that the transaction fee revenue is enough to compensate for the impermanent losses in yield farming.
- Choose low-volatility crypto token pairs so that they do not have a considerable effect of crypto market volatility on their prices.
- Look for yield farming platforms that allow a flexible pool ratio of the tokens, that is, they do not require investors to stake token pairs in 1:1 ratio.
- At the time of formation of the pool, the prices of the locked tokens are bound to change in the market. But as the time passes by and more people begin investing in the liquidity pool, the prices may come back to normal. So, the investors can wait till this time to avoid impermanent losses.
While farming yields in a liquidity pool, the investors must be very careful to avoid losses in yield farming. Make sure that you read the terms and conditions of the yield farming protocol carefully and familiarize yourself with the working of the protocol. As we have stated above, impermanent losses are inevitable, the investors must also consider the rewards offered by the protocol so that they can determine whether the losses are even worth it or not. It is because each yield farming protocol offers a different set of rewards and native tokens. Therefore, you must know whether you would be happy to receive the tokens as rewards or not. Moreover, check out the APY for the liquidity pools that you are going to invest in so that you have an idea of the returns you can expect.
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