Impermanent Loss
What is Impermanent Loss (IL)?
Impermanent Loss (IL) occurs when the value of your assets in a liquidity pool diverges compared to simply holding them in your wallet. This is primarily due to price fluctuations between the paired tokens within the liquidity pool. Providing liquidity earns fees and rewards, but significant price movements between token pairs can lead to reduced returns compared to holding tokens individually.
Rule: Impermanent Loss is realized only upon closing your position.
IL as Part of Your PnL
Your total Profit and Loss (PnL) from liquidity provision consists of three main components:
Trading Fees Earned: Rewards from providing liquidity.
Token Price Movement: Gains or losses from token price fluctuations.
Impermanent Loss: Potential losses incurred due to divergence in token prices.
Rule: Liquidity provisioning has a nonlinear (convex) PnL structure.
Directional Positions Within Range
Positions designated as Long or Short are valid only within the selected range of the liquidity position.
Exception: This rule might not apply if a position is initially opened out-of-range, depending on the chosen bounds.
When token prices move favorably within your chosen range, it might appear profitable due to fee earnings. However, once prices exit your range, your position stops generating trading fees and may incur significant impermanent loss upon exit.
Rule: Out-of-range positions generate only impermanent loss, no trading fees.
Effects of Leverage
Using leverage significantly impacts your impermanent loss:
Amplified Price Risk: Leverage multiplies the impact of price divergence, increasing impermanent loss potential.
Increased Borrowing Costs: Leveraged strategies require borrowing assets, adding interest costs that compound total losses.
Rule: Leverage amplifies impermanent loss.
Practical Tips to Manage IL
Opt for Wider Ranges: Wider ranges reduce sensitivity to price fluctuations, thereby minimizing IL, but may reduce fee earnings.
Conservative Leverage: Using lower leverage limits the extent of potential IL and provides more flexibility to manage your position.
Always carefully evaluate your risk tolerance and strategy alignment when setting ranges and leverage levels.
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