Interested in Providing Moon Liquidity on Sushiswap? A Beginner’s Guide to Impermanent Loss

If you are interested in providing liquidity to the ETH/Moon pool on Sushiswap to get more Moon rewards, you should know of the term “impermanent loss”, what it means and how it affects your crypto. I myself (and I am guessing I am not alone) have recently become interested in doing this so I did some learning and decided to make a post to talk about what this is, how it happens, and how you can minimize its impact. Keep in mind though, I am not a professional, this is just what I was able to learn. As always, DYOR.

Impermanent loss is a temporary loss that occurs when you provide liquidity to a pool of two crypto assets. It happens when the price ratio of the two assets changes compared to when you deposited them in the pool. The larger the price change, the more significant the loss.

For example (I’ll do my best), let’s say you deposit 1 ETH and 1000 Moons to the ETH/Moon pool. Assuming that at this point, the price of 1 ETH = 1000 Moons. The pool will use an automated market maker (AMM) algorithm that maintains a constant balanced ratio of the two assets.

Now suppose that the price of 1 ETH increases to 2000 Moons on an external market. This creates an arbitrage opportunity for traders who can buy ETH cheaply from the exchange you are providing liquidity on and sell it at a higher price elsewhere. As more traders do this, they will drive up the price of ETH on your exchange. To maintain the constant ratio, your exchange will adjust the amount of ETH and Moons in the pool accordingly.

Eventually, when the price of ETH on your exchange reaches 2000 Moons, there will be no more arbitrage opportunity and the trading will stop. At this point, let’s say there are 0.75 ETH and 1500 Moons left in the pool. If you withdraw your liquidity now, you will get back these amounts.

However, if you didn’t deposit your assets into the pool and kept them in your wallet instead, you would still have 1 ETH and 1000 Moons. But by withdrawing now, you only get back 0.75 ETH and 1500 Moons – a loss of value equivalent to 25% of your initial deposit of ETH. The opposite could also happen, where you would lose some of your initial investment of Moons instead.

It is called impermanent because it only exists when you withdraw your liquidity from the pool. If you keep your liquidity in the pool for longer and wait for the price ratio to return to its original state (or close enough), then your impermanent loss will decrease or disappear.

How Can You Reduce Impermanent Loss?

There are several ways to reduce or avoid impermanent loss when providing liquidity:

1) Choose pools with low volatility: If you expect that one or both of the assets in a pool will experience large price fluctuations over time (such as new or speculative tokens), then this will increase your risk of impermanent loss.

2) Choose pools with high fees: One way to compensate for impermanent loss is by earning fees from trading activity in a pool. The higher the fees are relative to volatility, the more likely you are to break even or profit from providing liquidity.

3) Choose pools with similar assets: Another way to reduce impermanent loss is by choosing pools that contain assets that have similar prices or correlations (such as stablecoins or wrapped tokens). This way, the price ratio between them will not change much over time, and thus your impermanent loss will be minimal.

4) Hedge your position: You can also use derivatives or other instruments to hedge against adverse price movements of one or both of the assets in a pool. For example, you could buy put options on ETH if you provide liquidity to an ETH/Moon pool, so that if ETH drops significantly, you can exercise your options and offset some of your losses. But this of course incurs its own risk and it is only advisable to do this if you really know what you are doing.

So, all in all, just know that the amount of crypto you put into a pool, might not be the same amount you get when you withdraw. And again, this is not professional financial advice and DYOR to know more.