In this article we will explain one of the most important things to take into account when providing liquidity in the traditional way (Farming), the impermanent loss or impermanent loss and we will give you several examples so you can understand it in a simpler way.
Let's imagine that you have decided to provide liquidity in a liquidity pool in a decentralized exchange protocol (DEX) such as Uniswap. To do so, you must deposit an equivalent amount of two different tokens tokens into the pool. In return, you will receive a proportional share in the pool.
Impermanent loss refers to the temporary losses you might experience as a liquidity provider when the price of the underlying tokens in the pool changes compared to holding those tokens separately.
Let's say you have deposited 1 ETH and 1000 USDT in an ETH/USDT pool. If the price of ETH increases significantly compared to USDT, the total value of your funds in the pool will increase. However, this also means that you will have less ETH compared to the starting amountsince some of your ETH has been used to maintain the balance of the pool.
If at some point you decide to withdraw your funds from the pool, you will get an amount of ETH and USDT proportional to your participation in the pool. This is where impermanent loss becomes relevant: if the price of ETH has increased significantly compared to USDT, you may end up with less total value compared to if you had held your tokens separately.
However, it is important to note that the impermanent loss is "temporary" because it is only realized when you withdraw your funds from the pool. when you withdraw your funds from the pool. If token prices return to their original state or balance, impermanent losses are likely to decrease or disappear altogether.
Impermanent loss is a concept to consider when providing liquidity in liquidity pools, and you should carefully evaluate the risks and benefits before participating. Diversifying your investment and understanding market dynamics can help you mitigate the impact of impermanent loss.
Here is a practical example so that you can see it more clearly and make your own calculations for your investments.
Let's imagine that we want to invest in a CAKE pool with BNB, and at that time CAKE is worth $10 and BNB $200. Since we have to deposit a proportional amount in dollars of the two currencies, we should deposit 100 CAKE tokens and 5 BNB tokens, so that we have an amount of 1000$ in each currency and a total of 2000$ of investment.
| CURRENCY | QUANTITY | PRICE | INVESTMENT |
| CAKE | 100 | 10$ | 1000$ |
| BNB | 5 | 200$ | 1000$ |
After some time, it is normal that the two currencies have changed in price, and this will affect our investment if they have not had a similar performance.
Let's imagine that in that period of time, the CAKE token becomes worth twice as much, $20, and the BNB token half as much, $100. In that case, so that the dollar amounts of the two currencies remain proportional, our investment would look like this.
| CURRENCY | QUANTITY | PRICE | INVESTMENT |
| CAKE | 50 | 20$ | 1000$ |
| BNB | 10 | 100$ | 1000$ |
As you can see, we still have $2,000 of investment, the same amount we had at the time of the initial deposit.
But this is where the impermanent loss becomes palpable, since if we withdraw our investment, we will receive the amount of tokens from the second table, which have the same value as the initial deposit, but less than if we had left the two coins separately.
| CURRENCY | QUANTITY | PRICE | INVESTMENT |
| CAKE | 100 | 20$ | 2000$ |
| BNB | 5 | 100$ | 500$ |
As you can see, having bought the coins separately, we would now have $2500 instead of $2000. This means a difference of $500, which, if we have not amortized with the profits from the pool, does not compensate us.
To perform these calculations, you can either do it manually, or you can use the famous impermanent loss calculators to estimate how much you could be losing compared to simply holding the tokens separately.
We leave you the link to one of the best known:
https://dailydefi.org/tools/impermanent-loss-calculator/
The Impermanent Loss problem is one of those that are solved thanks to the provision of concentrated liquidity that is used through established price ranges, which we will talk about in the future.
So stay tuned to our blog, where we will upload interesting information about all the ins and outs of this complex and fascinating world of DeFi.
