Before anything else, let’s define what exactly is impermanent loss (IL). IL occurs when the value of your LP tokens decreases below the initial investment due to price fluctuations in the underlying assets. This can happen even if you don’t sell anything! It’s like buying a stock and then watching it plummet before you have time to sell, but with crypto.
Now that we understand what IL is, why it happens. The main reason for IL in yield farming is the concept of price slippage. When you add liquidity to a pool, your assets are immediately sold at the current market price and then used to provide liquidity for other traders. This means that if the price of one asset goes up while the other stays the same or decreases, you’ll end up with fewer LP tokens than what you initially invested.
Here’s an example: let’s say you add $100 worth of ETH and DAI to a pool with a 50/50 ratio (meaning each asset is worth half the total value). If the price of ETH goes up by 20% while DAI stays the same, your LP tokens will be worth less than what you initially invested. This is because when you add liquidity to the pool, your assets are immediately sold at the current market price (which includes the new higher price for ETH).
So how can we avoid IL? Well, there’s no surefire way to completely eliminate it since it’s a natural part of yield farming. However, here are some tips that might help:
1) Choose pools with low slippage this means the difference between the current price and the price at which your assets will be sold when you add liquidity is small. This can help minimize IL.
2) Diversify your portfolio don’t put all of your eggs in one basket! Spread out your investments across multiple pools to reduce risk.
3) Monitor market conditions keep an eye on the prices of the assets you’re investing in and be prepared to adjust your strategy if necessary.
4) Use a yield farming calculator these tools can help you estimate how much IL you might experience based on current market conditions and other factors.
5) Don’t panic sell! Remember that IL is temporary and will eventually reverse itself as prices fluctuate over time. Holding onto your LP tokens for the long term can lead to higher returns in the end.