Yield Farming: How to Avoid Impermanent Loss

Impermanent loss (IL) occurs when price volatility within a trading pair causes a temporary loss of funds for the liquidity provider. You can incur an impermanent loss when you supply liquidity to a liquidity pool and your deposited asset(s) decline in value. Liquidity providers realize impermanent losses only when they withdraw their funds from the pool. However, if the asset price rebounds, liquidity providers are no longer affected.

Can Impermanent Loss be Avoided?

As long as the crypto market remains volatile and unpredictable, liquidity providers cannot avoid impermanent losses. However, smart investors can take specific measures to control the degree of impermanent loss they experience when locking their assets in a liquidity pool.

Some of these strategies for mitigating impermanent losses include:

• Using Stablecoin Pairs: Providing liquidity in stablecoin pairs like USDT and USDC will help offset impermanent loss since both trading pairs are stable (pegged to a stable asset) and immune to the crypto market's volatility. The downside is that your stablecoins will remain the same value, even if the market is bullish.
• Using Mirror Assets: If you don't intend to contribute stablecoin pairs, you can reduce impermanent loss by using tokens that follow similar prices. Examples of token pairs like these include sETH/ETH and DAI/USDC. These tokens have minimal price divergence and will not deviate too much when there is volatility.
• Waiting it out: Impermanent loss, as the name describes, is not a permanent loss unless you withdraw your funds from the pool. Therefore, an ideal strategy to avoid it is to exercise patience, wait out the volatility, and hope the prices rebound before withdrawing from the protocol's pool.

Is Impermanent Loss Common?

When investing in any DeFi protocol, it is best to look beyond the short-term consequences of impermanent loss because impermanent loss is common and difficult to avoid. As a result, you should expect a good amount of IL, and you should factor it as part of your liquidity pool investment risks. The best strategy is to ensure that the yield you earn from the pool is sufficient to cover all potential yield farming risks.