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Liquidity has a significant impact on asset prices and is therefore crucial in both traditional markets and DeFi. Anyone who has invested their wealth in DeFi knows the immediate risks of a liquidity pool, including temporary losses.
As we explain what Impermanent Loss means and how it works, we will also discuss why it essentially happens and how investors can minimize or prevent this risk.
Ephemeral Loss is the temporary loss of funds when an investor provides liquidity to a pool and the relative price of the deposited asset changes compared to its original value during the deposit.
Think of it as the opportunity cost of the funds you lose when investing funds in a liquidity pool.
You can do two things with your cryptocurrency: earn income from it or HODL.
HODL is crypto slang for “Hold On to Dear Life”. It is the same as a buy and hold investment strategy.
Before we continue, here are some points to consider with a liquidity pool:
- Number of tokens A x number of tokens B = k (constant)
- Number of tokens A x price of token A = number of tokens B x price
(If you are unfamiliar with the above concepts, see “Liquidity Pools” for a simplified explanation.)
Temporary loss may occur in the following scenarios. Let’s understand these cases with examples.
- The price of a token increases drastically
- The price of a token falls drastically
- The price of both tokens moves in the opposite direction
The funds were originally invested in the DAI/ETH liquidity pool
Let’s say we’ve invested $10,000 in one DAI/ETH liquidity pool. Since the initial deposit is to be made at a 50:50 ratio, we have provided liquidity of 2.5 ETH & 5000 DAI.
Case 1: ETH price increases by 50%
Value of our tokens in the liquidity pool if the price of ETH increases by 50%
When we invested in the liquidity pool and the price ETH up 50%our initial deposit of $10,000 is it worth it now $12, 247.44 . Congratulations!! We turned it into a profit $2247.44 or 22.47%.
But wait, if we just kept our tokens, they would be worth now $12,500whereby we make a profit $2500 or 25%.
Although we made a good profit by putting our money in the liquidity pool, we incurred costs $253 loss of potential winnings.
Ours ephemeral loss Is 2.02%.
Case 2: ETH price falls by 50%
Value of our tokens in the liquidity pool if the price of ETH falls by 50%
Let’s take another example. This time, ETH price fell by 50% instead of 50%. Our total pool value went from $10,000 To $7071.06resulting in a loss of $2,928.94 or -29.3%.
But if we had only held on to our tokens, they would be worth now $7,500. This would result in a loss of $2500 or -25%.
So this time ours The temporary loss is -5.72%.
current price as a percentage of the original price
The chart above illustrates how large a liquidity provider’s temporary loss can be in terms of the price movement of that asset.
It is important to know that regardless of the price direction, a temporary loss can occur.
The larger this difference, the greater an investor’s exposure to loss. It is important to know that regardless of the price direction, a temporary loss can occur.
Or in other words:
A 1.25x price change results in a 0.6% loss compared to HODL
A 1.50x price change results in a 2.0% loss compared to HODL
A 1.75x price change results in a 3.8% loss compared to HODL
A 2x price change results in a 5.7% loss compared to HODL
A triple price change results in a 13.4% loss compared to HODL
A 4x price change results in a 20.0% loss compared to HODL
A 5x price change results in a 25.5% loss compared to HODL
Note that the loss is the same regardless of which direction the price change occurs. A doubling in price results in the same loss as a halving. ETH with an initial price of $2000 – its temporary loss would be the same, -5.72%, regardless of whether the price doubles to $4000 or halves to $1000.
In our previous two cases, only the price of ETH moved. It gets more difficult when our two checkers start moving. This time we will change our pool. Let’s say we have a new token called Kitty Tokens or KTY.
And we will provide liquidity KTY/ETH pool.
The funds were initially invested in the KTY/ETH liquidity pool
Our first deposit was fraudulent $10,000. We provided 5000 KTY and 2.5 ETH to the pool.
Value of our tokens in the liquidity pool if the price of KTY increases by 50% and ETH decreases by 50%
If the price of KTY up 50% and ETH down 50%our total pool value went from $10,000 to $8,660.25 .
By investing in a liquidity pool, we Loss of $1339.75 or -13.4%.
If we had just kept our tokens, they would still be worth $10,000 (i.e. 5,000 KTY tokens worth $1.5 and 2.5 ETH worth $1,000) & we would have suffered no loss.
That’s what makes us fleeting loss be $1339.75 or -13.40%.
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