The fear of impermanent loss (IL) is the end of liquidity mining. A lot of people dread impermanent loss and avoid liquidity mining altogether as a result.
In this post, I would be sharing with you how to manage or completely avoid impermanent loss. So that you can confidently provide liquidity to your favourite token pools and farm those juicy yields.
But first, let’s talk about liquidity mining pools where the impermanent loss occurs.
Understanding liquidity mining pools
To understand impermanent loss properly, you need to know what is liquidity mining and how liquidity pools work.
In standard liquidity mining pools, you have to deposit two different coins of equal value.
For example, in the BCH-CST pool on MistSwap, you have to deposit both BCH and CST of equal value to participate in liquidity mining.
That means if you want to invest $1000 in the pool, you must buy and deposit $500 worth of CST and $500 worth of BCH.
At the current price of $1.4 for 1 CST and $322 for 1 BCH, you will be adding 357 CST and 1.55 BCH to the liquidity pool.
By participating in liquidity mining, you earn a share of all trading fees generated in that pool.
Now when people buy more CST from the pool using BCH, the price of CST goes up relative to BCH.
At the same time, the amount of CST you have in the pool reduces while your BCH grows. This is because people are taking more CST from the pool and leaving you with their BCH.
This is where impermanent loss sets in.
If you had held your BCH and CST in your wallet, would you have made more money in $USD than you would from the trading fees generated?
What is impermanent loss?
Impermanent loss simply means “reduced gain” or “the cost of doing business in liquidity mining”. It is the temporary difference, in value, between holding your crypto assets in your wallet and adding them to a liquidity pool on a DEX.
The term is used to refer to the difference in the value of your crypto assets between when you initially deposited them into a liquidity pool and now.
The more the prices of the tokens deviate from when you made the deposit, the higher your impermanent loss will be.
How does imperment loss work?
Do I still suffer impermanent loss even if the dollar value of my investment is higher thn when I started?
Yes! You would probably be making less profit than if you had just held the tokens outside of the pool.
As long as the price of the tokens you deposit into a liquidity pool does NOT remain exactly the same as when you deposited them, you’re going to suffer from impermanent loss.
The price of one or even both tokens could rise significantly over time, giving you massive gains.
But that also wouldn’t stop you from incurring impermanent loss, except they both grow at the same rate from the time you deposited them into the pool (a very unrealistic expectation).
However, the extent of the impermanent loss you suffer depends entirely on how much either of the tokens has grown relative to the other.
The greater the difference in their prices relative to when you deposited them into the pool, the greater the % of IL suffered and vice versa.
In essence, impermanent loss just means that you would have made more money holding your crypto assets in your wallet than adding them to a liquidity pool.
It is the opportunity cost of liquidity mining compared to just holding your crypto assets.
A reversal of this is when the fees generated in the pool is sufficient to offset the impermanent loss, but that rarely happens.
But all hope is not lost, as I’m about to show you how to completely avoid the impermanent loss in liquidity mining or at least, minimize it.
The top 5 ways to manage or avoid the risk of impermanent loss
Below are my top 5 liquidity mining strategies for completely avoiding or managing impermanent loss.
- Stake single tokens
- Invest in high APY pools
- Add liquidity to stablecoin pairs
- Provide liquidity to low volatility pairs
- Invest in flexible liquidity pools
1. Stake single tokens
The most straightforward strategy to completely avoid impermanent loss is to stake in a single token pool.
This way, you’re only exposed to the volatility risk of the asset while growing your stack with a healthy APY.
The bright side of this is the you’re earning more of the token with a high APY while hpopefully, the price increases significantly with time.
However, note that the price of the token could also tank. So that, even when you’re earning more of it with a high APY, you’re losing a lot more in $USD with the falling price.
So keep that in mind when you decide to invest in a single token staking pool, and only invest in tokens with solid use cases which will sustain demand and ultimately, its price.
Furthermore, some single staking pools allow you to stake one token and earn another. Those are also worth exploring.
2. Invest in high APY pools
The second best way to completely avoid impermanent loss is to find liquidity mining pools with very high APYs that will offset any impermanent loss.
At this point, you’re increasing your risk by chasing high APY pools, but with higher risk comes higher reward, right?
For example, I’m invested in the DIBS-BNB pool with auto compounding on Beefy with an APY currently at over 79000%.
This translates to about a 1.8% return on my investment daily.
This pool is great because BNB is an excellent coin and DIBS is technically a stablecoin of some sort, plus that insane APY.
Of course, this return will not last forever, but for as long as you can find such pools, take advantage of them to grow your portfolio.
Furthermore, some liquidity pools offer double earning opportunities.
2.1 Earn higher APY with yield farming
For example, in addition to the trading fees you earn by providing liquidity, you can stake your liquidity provider (LP) token to earn another token.
This is called yield farming.
For example, when you provide liquidity to say, the CAKE-BNB pool on PancakeSwap, you can stake your LP token on PancakeSwap farms to earn more CAKE in addition to the trading fees from the pools.
This double earnings, when combined, will usually offset any imermanent loss.
3. Add liquidity to stablecoin pairs
Another great way to avoid impermanent loss altogether is to invest in stablecoin pair liquidity pools.
For example, providing liquidity into a USDT-BUSD or DAI-UST liquidity pool will protect you from impermanent loss as their prices are stable.
The only downside to this strategy is that the APY is usually very low as there’s very little trading volume.
People don’t trade stablecoins against other stablecoins that much, hence, the low volume.
Plus as you already know, with low risk comes low potential reward.
4. Provide liquidity to low volatility pairs
You can minimize impermanent loss by providing liquidity to low volatility pairs such as:
- A token paired against a stablecoin, e.g. the CST-flexUSD pool on MistSwap.
- Two blue chip coins with high marketcap and relatively low volatility paired against each other, e.g. BTC-ETH.
In the first example, the impermanent loss in a CST-FlexUSD pool is far lower than say, a CST-BCH pool.
if CST is dumping for example, you’re automatically buying the dip as people take more stablecoin and leave you with CST.
Similarly, if CST is pumping, you’re automatically taking profit as people take more CST from the pool and leave their stablecoins.
All in addition to the fees generated from their trading activities.
But if CST goes to zero ($0) you lose everything.
That’s why you should not provide liquidity for a token with no potential or sustainable use cases in the first place.
Furthermore, providing liquidity for two blue chip coins like ETH-BTC with relatively low volatility and usually high volume will reduce the impact of impermanent loss.
This is because these coins have relatively low volatility, plus their volume is usually high which means smore fees generated for liquidity providers.
However, with greater volume and limited risk comes increased competition as more people will be providing liquidity to these pairs.
Thus reducing each persons potential share of the trading fees.
5. Invest in flexible liquidity pools
Remember we said liquidity pools usually require you to deposit two tokens of equal amounts (50:50).
That’s true, but there modern liquidity pools that allows you to deposit a single token or disproportionate amount of multple (2 or more) tokens.
These pools are designed to help you minimize impermanent loss as changes in the price of pooled tokens does not cause as much impermanent loss as in a 50:50 pool.
Impermanent loss calculators
What is the impermanent loss of your investment?
You can easily calculate impermanent loss and better understand how liquidity pools work by using the following impermanent loss calculators.
Simply enter the relevant tokens data and the calculator will show you how much impermanent loss you have incured.
Popular impermanent loss calculators:
- WhiteboardCrypto impermanent loss calculator
- Daily DeFi impermanent loss calculator
- UPoint impermanent loss calculator 1 and calculator 2
- Descent Yields impermanent loss calculator
- Uniswap V3 strategy simulator
Successful liquidity mining requires thorough research and developing a strategy that works for you.
And that includes finding ways to avoid or manage the much dreaded impermanent loss.
In this post, we have discussed several ways to avoid or manage impermanent loss, such as:
- Investing only in single token staking pools where you earn more of the same or a different token.
- Deposit into pools with high APYs or multiple earning opportunities that can offset the impermanent loss.
- Investing only in stablecoin pairs with reasonable APY.
- Adding liquidity to low volatility pairs to reduce impermanent loss.
- Leveraging flexible liquidity pools to minimize impermanent loss.
Which is your favourite way(s) to avoid or manage impermanent loss? Share with us in the comments section below.