Impermanent Loss is the risk exposed to Liquidity Providers as the price (amount of two tokens) changes in the liquidity pool compared to the initial price when liquidity tokens are added.
The more volatile the price changes, the larger the Impermanent Loss will be
Impermanent Loss is inevitable as far as the AMM protocal is conerned. So why would Liquidity Provider still provide liquidity if knowing they could potentially lose money?
LPs are compensated primarily via Trading Fees (LP fees) and Yield Farming
It is very important for users to understand Impermanent Loss before adding liquidity to the pools. A detailed explanation of Impermanent Loss can be found in this Binance Academy Article. We hereby provide a numerical example of how impermanent loss is calculated.
- Bob deposited 1 BNB and 100 BUSD
- After deposit, the pool has 10 BNB and 1000 BUSD
- Share of pool = 10%
- Value 0 = $200
- 1 BNB = 400 BUSD
- Constant Product () = 10,000
- Pool has now 5 BNB and 2,000 BUSD (5* 2,000=10,000)
- BNB amount = 0.5
- BUSD amount = 200
- Value 1 = $400
It would appear that Bob has earned $200 ( Value 1 - Value 0 ). However, if Bob had not deposited the 1 BNB and 100 BUSD at Time 0, its total value would have become $500 ($400 + $100) at Time 1.
Bob's Impermanent Loss would be $500 - $400 = $100