Providing liquidity to a liquidity pool may result in impermanent losses. This is something you do not wish to see but it is almost inevitable.

The prices of deposited assets will change compared to when they were deposited. The greater the the change, the higher the probability of suffering from impermanent losses. Impermanent loss means that the total asset value at the time of withdrawal (end of liquidity provision) is lower than the value of the deposit.

Knowing that it may suffer impermanence losses, why do liquidity providers still provide liquidity? This is because impermanent losses can (usually) be offset by LP rewards. If the prices of assets in the pool are within a relatively small range of changes, the risk of impermanent losses will be reduced. After all, the reward tokens which you receive from providing liquidity are probably more than enough to cover the impermanent loss. For example, if the impermanent loss is $100 and you have received $150 worth of reward tokens, you still make a profit of $50.

L.P platforms charge a commission for each transaction. If the trading volume of a given fund pool is extremely high, even in the condition of huge impermanent losses, it can still be profitable to provide liquidity.

How does impermanent loss occur?

Let's say you deposited 1 ETH and 100 CAKE in the liquidity pool. The price of ETH is $2,000 and the price of CAKE is $20. At this point, your assets are worth:

(1 ETH X $2,000) + (100 CAKE X $20) = $2,000 + $2,000 = Total $4,000

To ease our calculation, let us assume that you are the only liquidity provider in the pool (in actual case there may be thousands of providers like you in the same pool).

Suppose the price of 1 ETH rises to $2,500 and the price of CAKE remains unchanged at $20. The arbitrage traders inject CAKE into the pool and remove ETH until the ratio reflects the current price. The factor that determines the price of assets in the pool is the proportion of different assets in the pool. In this case, the AMM will adjust the quantity of ETH to 0.89443 and CAKE to 111.8 using a certain formula. Although the quantity ratio in the pool has changed, the overall liquidity ratio still remains the same at 50%-50%.

(0.8944 ETH X $2,500) + (111.8 CAKE X $20) = $$2,236 (ETH) + $2,236 (CAKE) = Total $4,472

If you decide to withdraw the funds, the amount you will get back is $4,472 (we will not take into account the rewards yet for calculation at this stage).

Now let's see what will happen if you do not provide liquidity and simply keep the assets in your wallet. The asset value, if holding, will be:

(1 ETH X $2,500) + (100 CAKE X $20) = $2,500 + $2,000 = $ Total $4,500

The results show that compared to depositing in the liquidity pool, you can obtain higher returns by holding these assets.  The difference is $4,500 - $4,472 = $ $28. This is the so-called "Impermanence Loss."

In the above case, your loss is very small and the initial deposit amount is relatively small. However, it should be noted that impermanent losses can cause significant losses as the invested value goes much higher.

Having said that, this case completely ignores the rewards that you earn by providing liquidity. Most L.P platforms provide special reward tokens (such as CAKE, BONE, BANANA etc.) to attract investors. If you have made more than $28 worth of rewards in this case, the investment has made a profit.

Don't forget that you will also be charged gas fees for depositing and withdrawing your funds. Under the Binance Smart Chain (BSC) Network, the gas fees might go as low as just a few cents. On the other hand, the gas fees for Ethereum Network can go insanely high!

Simulation with UPOINT Impermanent Loss Calculator 1

You may see  the simulation of the above calculation with the calculator. All values in the example have been inserted for your convenience.

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