Transcription
Impermanent loss is the number one reason why beginners are afraid of deploying capital into liquidity pools. And in this video, I'm going to be breaking down exactly what impermanent loss is, why it matters, the risks that actually holds, and how we can manage it a little bit better inside of our portfolio.
Now, I've been running the UIG for five and a half, almost six years now, which is crazy to say out loud. And I get these questions all the time of like, "Hey, I'm really excited about the cash flow of liquidity pools, but impermanent loss is impermanent loss that, and I just don't want to deploy capital until I fully understand it." And I say, "I I agree with you. I think that's a great thing."
And I'm actually going to tell a little bit of a funny analogy that I use in my teachings in the UIG, and that's the movie Monsters Inc. I'm not sure if you've seen it, but in Monsters Inc., the monsters uh would go into the rooms of the children and scare them, right? And the screams they would collect as energy. Well, the monsters were deathly afraid of the kids. There was like this this back and forth where the kids were really scared of the monsters, the monsters were really scared of the kids, meaning if the kids touched them, they thought of that as like the worst thing in the world, right? And so, the the idea of the movie is that the kid actually escapes the room and kind of grows a relationship with one of the monsters, and the monster realizes, "Wait, this is not as scary as we all think. Like, these kids are okay. Like, there's nothing to be afraid of." And the crux of that movie is that he learns more about it.
And so, what I would challenge you to do in this video and and elsewhere in your own studies is to really just learn about what impermanent loss is. Because impermanent loss is not something that we need to be deathly afraid of, right? This is something that is naturally occurring inside of liquidity pools, but we can understand it, and we can manage it a little bit better. So, hopefully you like my analogies. There's a lot more where that came from inside the UIG, but today I'm really going to be diving into what IL is and how we can manage it, and how we can think about it.
Well, the main reason or the main way that I think about impermanent loss is opportunity cost. It is what could it have been if I had this in spot holdings as compared to an LP. And so, a very easy teaching that I like to use is just using two scenarios. Scenario number one is if you had taken this capital and just held it in your wallet, what would the dollar value of that portfolio be when the market moves? When the market goes up, when the market stays the same, and the market goes down. What is the dollar value of this portfolio when the market when ETH moves up 20% or when ETH moves down 20%? Compared to if you were to take that same amount of capital, the same quantity or ratio of assets, and put those into a liquidity pool, what would that dollar value be worth if the market moved, like I said, 20% up or 20% down, etc., etc., right? So there's a bunch of different scenarios that we can run.
I'm actually going to use DeFi Buddy here in a minute to show you what that could look like when the market moves 5% up, 5% down, 20% up, 20% down, 50% up, 50% down because impermanent loss is the difference between these two scenarios. And the biggest thing that I hear, and it's just it's just wrong and I have to correct it in the most polite way possible that way that I can, is a lot of people will just equate dollar value loss in their position to impermanent loss. I'll give you an example. If somebody puts in $5,000 into an ETH USDC liquidity pool and ETH pulls back 10% and that liquidity pool goes from $5,000 of value down to $4,500, right? So it goes down by $500. What I hear a lot is, "Oh, I have $500 of impermanent loss." And that's just not accurate, right? You have a $500 paper loss, right? And if you haven't exited the position, it's not a real loss because if the price of ETH goes back up to the original ratio, everything kind of goes back to normal, right? And so you didn't actually lock in any losses during that point. And that's where I think people get confused cuz they think, "Oh, impermanent loss, you know, the price has gone down, but if the price comes back up, it goes back to the original ratio, everything is is good, right?" And that's that's true, but it's slightly different.
The the the verbiage we need to be really clear that impermanent loss is the difference in dollar value between the LP and if it was being held in the wallet. So, what I'm going to do is I'm actually going to go into DeFi Buddy and actually show you this setup and and and walk through these two different scenarios and what happens when the price moves up and moves down. But, before I do that, I actually did want to show TradingView really quick because TradingView, um I can I can very clearly map out how I've been burnt in the past using liquidity pools and not really understanding um how impermanent loss gets locked in.
So, impermanent loss gets locked in when we rebalance, right? When we close our original position and we rebalance into a new position. And when we do this, we are cutting off we are we are not allowing the price to go back to the original starting point, to the original ratio. And when we rebalance or when we close that position, we are cutting off the ability to get there, hence we are locking in the impermanent loss. And again, impermanent loss is is just the dollar value difference between being in an LP and being holding in a wallet. And so, if you're in a liquidity pool for cash flow, impermanent loss is something to be aware of, but it is not something to be deathly afraid of because these are two different vehicles. Vehicle number one is holding assets in a treasury, meaning we're holding it in spot. And then as and then scenario number two is holding in an LP where we're more so focused on cash flow. So, when we're in an LP, impermanent loss is is a naturally occurring. It's going to happen. We just want to manage it and be aware of it. We don't want to be rebalancing every 15 minutes because if we do that, we're going to be locking in a lot of impermanent loss.
And this is where I got burnt real bad um way back in the day when I was doing this is because every time I would go out of range, I would just rebalance my pool and I would rebalance my pool and I would rebalance my pool and I would rebalance my pool. And every single time I went out of range and I was rebalancing, I I locking in impermanent loss. And when you lock in impermanent loss over and over and over and over again, the dollar value of that LP is going to shrink over time. So, yes, I'm generating cash flow and that's amazing, but we don't want to be really frequently rebalancing our liquidity pools, right? There's there's a there's a happy medium to be found. There's a sweet spot in terms of how often do we rebalance and how often do we not rebalance? It also really determines on or depends on how wide your range is as well. So, there's like a dozen different variables that I can talk about and if you're wanting to go much deeper, we do have a free DeFi course that you can go through as well as some DeFi investor tools that I think will be awesome for you to go to and actually kind of see how these things play out in real time.
Um but what I wanted to do is actually show you on DeFi Buddy in the tool section because there's an impermanent loss calculator, which we can simulate different scenarios. So, what I'm going to do is I'm going to come down here to my initial position and I'm going to do a $10,000 position. And I'm going to um put the current price right in the middle of the range. And I'm going to do a 20% wide range, right? So, I have on the lower side uh 2039, on the upper side uh 2000 uh 492. So, current price is pretty much right in the middle, uh about 10% down, 10% up. $10,000 position, meaning I have 2.098 ETH and 5244 USDC as the starting ratio or the starting capital for that position. Now, what I'm going to do is I'm actually going to remove the LP yield for now because I do not want that to uh play a role in the dollar value difference between scenario A and scenario B, okay? Later on, I'm going actually going to add in that LP yield and we can see how why we would want to be in an LP in the in the first place.
Okay, so I'm going to move myself over here. Now, strategy A, this is if we were to have held these assets in a wallet, right? Strategy B is if we were to be in the liquidity pool. And so, you can see at the starting line as the current price and the future price are the exact same, the ratio of my assets are the exact same, and the dollar value of these are the exact same. But, what happens when I start to move the future price of ETH? If I were to move the future price of ETH to uh let's call it um 2,000 uh 100, right? 2,100. What does that do? As the current price has moved down in the towards the bottom of my range, you can see the dollar value of both scenarios have gone down. Because in scenario A, I still have the same exposure to ETH. And so, as ETH has gone down in value from 2266 to 2100, the dollar value of my entire portfolio has gone down by $349, right? In the LP, same scenario. However, in a liquidity pool, as as you may know, and if you don't, we have a DeFi course that'll walk you through this. As the price of ETH goes down, my USDT C is getting converted into more ETH. As you can see, the the quantity of my ETH has increased. And so, as I'm getting more exposed to ETH as price goes down, the dollar value of this position is going to go down faster than if I were to have maintained the same quantity of ETH as the beginning. And so, the dollar value of both of these scenarios have gone down, but the LP has gone down even more because again, I have more exposure to ETH. Impermanent loss is not a $491 loss. That's just a paper loss. The impermanent loss is $142 because that's the difference between strategy A and strategy B. Okay?
Now, what happens if the future price goes up? If the future price of ETH goes up to 2400 towards the top of my range, you can see both scenarios have gone up. I've made dollar value money profits in both directions. However, I would have made more in strategy A by holding because I have more ETH exposure than I do now. Because again, when the price goes up in the range, my my ETH is getting converted into USDC. And so the impermanent loss that I'm experiencing is $86. And so as you can see here, even though the dollar value went up from 10,000 to 10,194, I made money in this portfolio in this position rather, I still have impermanent loss that's being experienced.
Now if I were to add in um some LP yield, let's go up point two, right? 73% APR just as an example, right? And I were in range for let's call it um two weeks, 14 days. You can see here that in strategy A, it maintains the same as it as it was, but because I've generated $200 $280 LP fees in the last two weeks in this scenario, the LP actually wins. So even though the dollar value of the pool is up but lower than the being, you know, help hold like holding in the wallet, because I've generated yields, I've this strategy is actually outperforming. And the longer I'm in range here, the more profitable the LP strategy becomes because I'm generating fees.
So all I'm trying to paint a picture of here is that impermanent loss is naturally occurring whether the price goes up or whether the price goes down. This is going to happen if you're inside of a liquidity pool. This does not mean that we need to run for the hills or it's something that we should attempt to avoid because again, it's naturally occurring. What we need to do is manage it. And by managing it, the rule that I've come up with for myself over the last five years of doing this is I just try to rebalance as infrequently as humanly possible. Right? That doesn't mean that I never rebalance because I certainly do. I just try to do it strategically and do it in a way that doesn't lock in a ton of impermanent loss. And how we do that by how we lock in a bunch of impermanent loss is doing what we call a traditional rebalance. A traditional rebalance is when we're rebalancing back to the middle of the range where we put the current price back to the middle of the range. This locks in the most impermanent loss and so we just really need to make sure that we're strategically rebalancing and so there's things called a snuggle rebalance or a pseudo snuggle rebalance. Other strategies that we have throughout the UIG in the in the DeFi free course that you can learn about that can help you understand these concepts and help you better manage your liquidity pool.
So, like I mentioned, we have that free DeFi course and some free DeFi investor tools that it can be really really valuable for you to learn and really maximize your understanding of these concepts. Make sure to grab those links in the comments below and with that being said, we'll see you in the next video. Peace.