⚠️Impermanent Loss

Impermanent loss (IL) sounds scary, but it's quite simple once you see an example.

tl;dr

• With all AMMs, if price moves too far away from your initial price, you could have been better off just hodl'ing 💰

• If you make enough fees (desired fees/spread) from a lot of back-and-forth trading, you can still be profitable

• Volatility helps you make more fees! If prices keep bouncing up and down, you will make fees along the way. If prices return back to your starting price, your IL will be ~0 but the fees collected is profit 🤑

Impermanent loss is best explained through a real example.

Example

Let's suppose we created a market-make order by depositing some SOL (◎) and CryptoDuckz NFTs as liquidity 🦆

We're prepared to buy up to 2 Duckz for 3 & 2 ◎ each, and preapred to sell 2 Duckz for 4 & 5 ◎ each (starting price = 4◎, delta = 1◎). Suppose Duckz are valued at 4◎ right now.

So we deposit 3 + 2 = 5◎ and 2 Duckz (2 x 4◎ = 8◎).

Net worth: 13◎

Scenario 1: price goes up 📈

If Duckz go up in value to 5◎, traders might buy our 2 Duckz at 4 & 5 ◎. We now end up with our original 5◎, along with the 4 + 5 = 9◎ we received.

Net worth: 14◎

What if we just hodl'ed our Duckz initially? We would have the 5◎, but 2 Duckz valued at 5◎ each, meaning we could have a value of 15◎.

Could have had: 15◎

Scenario 2: price goes down 📉

Duckz plummet to 1◎ (😬), we're forced to buy 2 Duckz for 5◎ total (3 + 2), now we're holding onto 4 Duckz at 1◎ each.

Net worth: 4◎

What if we just hodl'ed? original 5◎ and 2 Duckz (1◎ each) = 7◎.

Could have had: 7◎

Now you can see how in both of these cases you lost money compared to the situation where you just HODLed. That's the essence of impermanent loss.

MM fees to the rescue 🪙

In both of those examples, we assume there was no back-and-forth trading and you did not collect any fees.

Suppose you collected 0.1◎ on every 1 buy + 1 sell (round-trip).

If prices fluctuate back and forth, 30 round-trips occur, you would collect 3◎ in fees. If prices return roughly to the starting price (4◎), your IL would be 0, so you would profit 3◎!

That's why it's called "impermanent" loss. It's only a loss if you sell when prices diverge significantly from the starting point.

If prices return to where they started, you lose nothing.