Mining, investing, and trading all pose risks that make it difficult to stay profitable in the market. Likewise, liquidity mining also has its own drawbacks that prevent users from providing liquidity without having to monitor the cryptocurrency market: impermanent loss (IL).
Many wonder what the mysterious IL is. However, many also mistakenly believe that IL is more complex than it really is. Calculating and predicting IL may be an entirely different story, but the basic functioning of impermanent loss is relatively simple.
Impermanent loss is defined as the opportunity cost of holding onto an asset for speculative purposes versus providing it as liquidity to earn fees.
Losses to LP due to price variation
Since digital assets are extremely volatile, it is almost impossible to avoid IL. If an asset within the LP of choice loses or gains too much value after being deposited, the user is at risk of not profiting or even losing money. For example, Ethereum can double in value within 5 days but the fees granted while farming it will not even cover half of what one would have made by HODLing.
Impermanent loss has rightfully earned its name. Losses are only realized if the user decides to withdraw his liquidity. Therefore, it is possible to avoid IL if the market returns to the original price. If that does not happen, LPs are forced to withdraw liquidity and realize their IL.
After exploring liquidity mining and yield farming you will have the chance to explore impermanent loss in more detail in a separate lesson.