How to Calculate Impermanent Loss?
Impermanent loss occurs when providing liquidity to a liquidity pool. It happens due to the volatility of assets involved in the pool compared to simply holding the tokens. Here’s how to calculate it:
Step 1: Understand the Initial Investment
When you provide liquidity, you deposit two tokens into a pool. For example, let’s say you deposit 1 ETH and 200 USDT, making your total initial investment worth $400 (assuming 1 ETH = $200).
Step 2: Determine New Prices
Next, track the prices of the tokens after a certain period. If the price of ETH increases to $300, the new value of your tokens changes.
Step 3: Calculate the Value of Your Liquidity Position
With the new price, your 1 ETH is now worth $300, and the USDT remains at $200, making the total value $500. However, your share in the pool has changed, and the amount of liquidity you hold in the pool will be converted based on the pool’s new ratios.
Step 4: Calculate Impermanent Loss
Impermanent loss can be calculated using the formula:
Impermanent Loss (%) = 2 * sqrt(P1/P2) / (1 + P1/P2) - 1
Where P1 is the initial price ratio and P2 is the current price ratio of the two assets.
Step 5: Consider Holding the Tokens
Finally, compare the impermanent loss to potential gains from holding your tokens. If impermanent loss is greater than returns from trading fees, you may reconsider providing liquidity.