TLDR: Impermanent loss is not actual loss.

I see many people which are terrified or just confused when it comes to liquidity providing. Most of the time, this is because everyone warns about "impermanent loss" and investors become reluctant to take the risk.

In this post, I want to clarify what IP is and when does it occur in simple terms.

First of all: impermanent loss is not actual loss, but less gain compared to holding the two assets separately.

This happens when one of the assets from the liquidity pool moves significantly compared to the price of the other.

I think examples always paint the picture much clearly, so here is one:

Example: Providing Liquidity in a USDC/ETH Pool

You provide liquidity in a USDC/ETH pool. Let's say you provided $500 worth of each. So your distribution is $500 of USDC / $500 of ETH.

Let's say ETH does a 2x during the year. That means that:

If you held them separately: you would have $1000 worth of ETH and $500 worth of USDC. So $1500 in total.

If you held them in a pool: As the price of ETH moves up, the pool will rebalance your position to 50/50. So you'll still make gains of ETH's rise, but a part of the ETH will be continuously redistributed to USDC to balance out the pool.

This means that you'll end up with slightly less ETH and slightly more USDC at the end. So you will lose some of the upside from the portion that will get redistributed to USDC.

Using the impermanent loss calculator (https://dailydefi.org/tools/impermanent-loss-calculator/), you would end up with $1414 in total.

So still up from your initial investment of $1000, but lower compared to not providing liquidity ($1500).

However, there is also the yield. If this pool yields for example 10% APY, you'll make around $100 in interest. This covers your "impermanent loss". Of course, this all depends on the APY and how the assets will perform.

The important thing to notice is how small this so-called "loss" is. So, if an asset doubles, you're only 5% better by holding the two separately. This means that impermanent loss can be devastating only in situations where assets move significantly from each other.

Use the calculator above to see what it means by providing the initial prices and the future prices.

Hope that this post was informative! Love you all and happy accumulating!

TLDR #2:

• $500 of USDC and $500 of ETH held separately, ETH does 2x, you have $1500.
• $500 of USDC and $500 of ETH in a liquidity pool, ETH does 2x, you have $1414 + the APY you earned.

Impermanent loss doesn't mean you're losing money, but that you're making less gains compared to holding the two assets separately.