What is impermanent loss?
I'm going give simple answers to a hard problem, because not all of us are math nerds! I'll also give some advice for avoiding impermanent loss.
The unhelpful technical definition is "impermanent loss is the difference between staking assets in a liquidity pool versus holding the assets".
My simpler definition: "impermanent loss is when you get the same AMOUNT of stuff back, but it's not the same VALUE". 1 bottle of water in the desert is the same AMOUNT as 1 bottle of water at home, but they have different VALUES. That bottle of water in the desert is worth way more.
Pun intended liquidity providing examples
In both examples, you start the day with $5 and 5 bottles of water. 1 bottle of water costs $1.
Example one: it's a hot day at the beach, and you're playing volleyball in the sand with some friends. They are thirsty, and offer to buy your bottles of water for $1 each. You sell all 5 bottles of water, now having $10 in your pocket. But after a while... you're thirsty too. And now you don't have water! Each friend who gave you a dollar for a bottle of water made a fair trade, and you ended the day with the same amount of assets. But the value of water changed. The $10 in your pocket doesn't solve your thirst problem. This is impermanent loss: the bottles of water are now worth more than the money.
Example two: after your day at the beach, you see a money making opportunity. You go to the store and buy 5 bottles of water for $1 each, bringing your total to 10 bottles of water. You head to the beach to sell them, but... it's raining. No one wants to buy your water. You have the same AMOUNT of stuff you started the day with, but the VALUE changed.
By providing liquidity, you're taking the bad side of every trade. If you're providing liquidity on WETH / USDC and ETH is rising, you'd be better of holding ETH. If crypto is dumping, you'd be better off holding stables. So why provide liquidity? Because we can earn fees with every trade!
The dream is for price to remain constant so you can collect fees forever without experiencing impermanent loss. And it's just that: a dream. Let's look at real world scenarios to maximize fees while minimizing impermanent loss.
Scenario one: Full, or wide range liquidity
The older verions of Uniswap and clones (Sushi, Pancake, Joe, Spooky, etc) have simple liquidity providing across the entire range: from 0 to infinity. These actually work really well! V2 pools, on average, are more likely to be profitable than V3 pools even though they generate less fees. This is possible because they prevent users from self harm by impermanent loss. We can act like a V2 pool by selecting a full range on our V3 pools.
We can improve on full range liquidity by narrowing the range somewhat. We'll still have a wide range, but not from 0 to infinity. Instead, try to pick a range that is likely to last several weeks or months. How? Look at how much price moved in the previous weeks/months, and create a range that is roughly that wide. If ETH/USDT moved $1000 in price, over the past month, simply create a range +-$500. Keep it simple! You're now generating increased rewards on your crypto while minimizing impermanent loss.
Scenario two: correlated assets
There are several types of assets that move together: WETH/X pairs, stable/stable pairs, and wrapped assets like staked ETH.
Staking stable/stable pairs is easy to understand. Since USDC and USDT are both pegged to be equal to $1, in theory we could stake in a tiny range collect fees without rebalancing. That theory holds up well, but so many people do this that the rewards generated are low.
WETH/X pairs are an interesting example. Crypto tends to move together. If BTC goes up against fiat, ETH does too. If ETH goes down against fiat, BTC does too. Thus, the values of ETH vs BTC don't change much. We can stake something like ETH/BTC and generate rewards with minimal impermanent loss while being short fiat!
Last, there are wrapped assets like staked ETH that should be similar in value to regular ETH. We can stake these in a small range and theoretically avoid impermanent loss.
Scenario three: don't
In wild markets where an asset is making new all time highs/lows, it can be better to not provide liquidity. There have been several times in crypto's history when markets have broken down. BitMex had to pause trading in 2018 to prevent BTC from going to 0. Stablecoins went to actual zero. Exchanges went down. During these times, it's usually best to get out of the market.
Those are some strategies to prevent impermanent loss. Too much to handle? Don't worry: TidePools.io does all of this automatically for you! Just pick your pool
, deposit, and generate rewards on your crypto. If you don't see the pool you want, you can create your own
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