What is Impermanent Loss?

Last updated 2 years ago

What is Impermanent Loss?

Impermanent loss (IL) is a common risk in DeFi for liquidity providers. The premise of IL is simple;

Impermanent loss occurs when the price of your tokens changes compared to when you deposited them in the pool. The larger the change is, the bigger the loss.

In other words, IL occurs as a tradeoff when you choose to provide your tokens into a liquidity pool, as compared to another scenario where you simply held on to your tokens on your wallet (hodl). The reason why IL occurs is due to the inherent design of automated market makers (AMM), which is the basis of almost all DEXes that you see.

Here's an example for you to visualize better.

Assume you provided liquidity to StellaSwap on our standard AMM for a total of $100, supplying Token A and Token B;

Price of Token A: $10
Price of Token B: $1

Therefore, you're supplying 5x Token A (for a total value of $50) and 50x Token B (for another value of $50), with a total value of $100. Assume Token A doubles in value, from $10 to $20, while Token B stays exactly the same.

In this scenario, eventhough Token A doubled in value, as an liquidity provider, you're experiencing IL as you'd be better off holding your tokens in your wallet.

The main reason why anyone would want to provide liquidity to a DEX is because they're putting their coins to "work" and earning 1)trade fees and 2) farming rewards. Therefore, it makes financial sense to LP if your total fees & rewards is more than the IL than you lose.

Impermanent Loss on Pulsar's Concentrated Liquidity AMM

So now you've understood CL. On Pulsar, the risk of IL is higher. Why? It's a simple trade-off. Pulsar allows you to choose your range and concentrate your liquidity. Concentration of your liquidity allow you to capture more fees with significantly less liquidity. This means, you'll earn more but face higher IL.

Important to note that on Pulsar, you can access be exposed to the same amount of IL as a standard AMM by providing full range. This means that you provide your liquidity across all liquidity ranges, which is what a standard AMM does. However, you earn lesser than someone that concentrates their liquidity.

Here's our Twitter thread for you to get a better idea;

What Happens When You're Out-of-Range?

This means you stop earning any trade fees or rewards since your position is out-of-range. But more importantly, your OOR position now consists of only one asset.

Here's an example;

You create a range on Pulsar for GLMR - USDC between $0.30 - $0.60, supplying 50% in GLMR and 50% in USDC
Current market price is $0.40, so you're still in-range
Went on a holiday and after 7 days, GLMR price went to $0.70
All your GLMR is converted to USDC, and you're OOR (since $0.70 is outside of your range)

The above example shows how you're exposed to IL, as your position is now ALL in USDC, so there's no chance of capital appreciation.

What Can I Do if I'm Out-of-Range?

So if you're OOR, here's two options that you face;

Withdraw your LP position and re-add your liquidity by swapping some USDC > GLMR
Wait for the price of GLMR to fall back to your preset range. However, you will not earn anything as long as you're OOR

Your next steps depend on your own strategy and risk appetite.

Mitigate Against Impermanent Loss

So far, you've learnt the concept of IL and its context within Pulsar. Given the possibility of higher IL, it is vital that you constantly monitor and re-balance your positions to ensure it doesn't fall OOR.

Going forward we're partnering with automated liquidity managers to enable you to passively manage your Pulsar liquidity. This means that you won't have to monitor your positions. Think of it as an equivalent of Beefy; they manage your positions for your and ensure you don't OOR. Do await further announcements!