How Impermanent Loss Works And How To Calculate It?

Impermanent loss is a concept that liquidity providers should be familiar with when participating in decentralized finance (DeFi) platforms like Panaroma Swap. Here's a comprehensive guide on how impermanent loss works and how to calculate it:

What is Impermanent Loss:

Impermanent loss occurs when the value of assets held in a liquidity pool diverges from what would have been the value if the same assets were simply held in a wallet. This loss is "impermanent" because it diminishes as the relative prices of the assets in the pool fluctuate.

How Impermanent Loss Works:

1. Asset Price Divergence:

   • Impermanent loss is most prominent when there is a significant divergence in the prices of the assets in the liquidity pool. If one asset appreciates more than the other, impermanent loss occurs.

2. Dynamic Pool Ratio:

   • Liquidity pools maintain a dynamic ratio of assets based on market prices. As traders swap between the assets, the pool's composition changes, and impermanent loss arises when this dynamic ratio deviates from the static ratio held in a wallet.

3. Temporary Nature:

   • The term "impermanent" implies that the loss is temporary. If the relative prices of the assets return to their original state, the impermanent loss diminishes.

How to Calculate Impermanent Loss:

The formula for calculating impermanent loss is as follows:

Impermanent Loss=2×�1×�2�1+�2−2Impermanent Loss=P1+P22×P1×P2​​−2

Where:

• $P1$ is the initial price of the first asset in the pair.
• $P2$ is the initial price of the second asset in the pair.

Key Points for Calculation:

1. Square Root Function:

   • The square root term in the formula represents the geometric mean of the prices. It indicates the average price change of the assets.

2. Comparing to Holding Assets:

   • The formula calculates the difference between impermanent loss and simply holding the assets. If the result is positive, impermanent loss occurs.

Mitigating Impermanent Loss:

1. Diversification:

   • Diversify across multiple liquidity pools and assets to spread risk.

2. Choosing Stable Pairs:

   • Opt for stable pairs or those with lower volatility to minimize impermanent loss.

3. Regular Portfolio Review:

   • Periodically review your liquidity pool positions and assess the potential impermanent loss.

Understanding impermanent loss and its calculation empowers liquidity providers to make informed decisions and manage risk effectively on Panaroma Swap. Regular monitoring and strategic adjustments can help mitigate the impact of impermanent loss over time.