3 rules of thumb for managing impermanent loss

3 rules of thumb for managing impermanent loss

By SpoilerAlert | Crypto For Monkes | 25 Nov 2021


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This posts builds on the topics covered in our Wrapping and Staking series. If you haven't read them yet, check them out and hte below will make a lot more sense.

Impermanent loss. If you've done a bit of staking and had a google around, sooner or later you will come across this term. If you're like me, after reading a few explainer posts, you still won't really understand enough about it to stop you from staking anyways, and YOLO straight into a yield farm. It won't be until you unstake for the first time and realise that your token balances are out of whack that maybe you should have paid more attention.

Don't worry, we've all been there, and hopefully the impact to your portfolio hasn't been too drastic.

I've been trying to work out the best way to explain what happens during impermanent loss (IL from now on) in such a way that your eyes won't glaze over, and the best way I can think to help you out with it is to provide a few rules of thumb that I use when deciding when and what to stake. 

Before that however, I'm going to try to distill IL down to a reasonably digestible definition. The following is a bit of an oversimplification, but will hopefully make it easier to process:

Impermanent loss is when the ratio of your staked tokens changes due to the price movement of the tokens. This means that when you unstake your tokens, you may find that you have more or less of the number of tokens that you invested, though they will represent the same total value as your LP token was worth.

The long and short of it is that if you stake your Banano and the price of Banano goes up in the meantime, when you unstake it again, you will have fewer Banano than you started with, because each Banano is now individually worth more. More on this below.

OK, hopefully that preamble helps you to understand IL a bit more, but either way, the following 3 rules of thumb should hopefully make a bit more sense and help you avoid some of the pitfalls of staking.

1. Pair with Stable Coins

Tracking LP value is tricky enough as it is. Having two volatile tokens in your stake can make it even harder. When staking, it's often better to use a stable coin in the pair, which will ensure that all of the coin movements within the LP is localised to the other coin you are staking.

Practically speaking, this will mean that when the value of your LP token goes up, the number of your non-stable tokens held will go down and vice-versa. 

 

2. Don't stake if your coin is going up

As described above, when you stake your tokens and the market price of that token goes up, then the number of the tokens you get back when you unstake will be fewer. 

To illustrate, let's say that you have $10 worth of Banano, and each Banano is worth $0.01. You stake this with a stable coin pair and leave it be for a month. At the end of the month, you decide to unstake your LP (for this example we'll be ignoring any interest earned). At the point that you unstake, the value of Banano has doubled. Great! But when you see what coins you ended up with, you find you now have fewer Bananos! What happened?

When you staked your Banano, you invested $10/10,000 wBan and $10 worth of stable coin, giving you a total LP value of $20. While it was staked, the ratio changed because Banano doubled. Now your $10 of Banano is represented by only 5000 Banano. You haven't lost any money, but you have suffered 'impermanent loss', which is another way of saying the opportunity cost between staking and holding.

Of course the opposite is true as well. If Banano slipped down to $0.05 while you were staking, you would emerge with 20,000 Banano instead! 

The moral of the story is check the market before you stake and if you think it's going up, then hodl, if it's going down and you want to accumulate more Banano, then stake. (this is not financial advice, just a strategy you can use if you decide to do so. Your money, your risk)

 

3. APY is your frienemy

If you've reached this far, you've learned that staking is a bit of a beast with a mind of its own. It can be hard to tame in a volatile market, but one of the tools available to help you out is yield farming. Yield farms allow you to earn interest on your staked tokens, allowing you to potentially earn more money for parking your LP tokens. 

What's great about crypto is that the APY (Average Percentage Yield - think interest, or even compound interest) available are often much higher than those available in your bank. By shopping around, you may find yield farms with rates into the thousands of percent!

Like everything though, there's no such thing as a free lunch. Generally speaking, the APY offered on any yield farm is a measure of risk. For almost any pair, there is a base APY that is relatively easy for a decentralised exchange to offer. This is largely due to the efficiencies gained with having a fully automated exchange, and generally speaking, the lower rates from 1-5% tend to involve stable coins and relatively low-risk operations. The APY generated from these can usually offset some of the fluctuations in value of your LP tokens, which mitigates the IL caused by token price movement.

Then there are the big APY farms. These are the ones offering 200%, 500%, even 1500% for you to stake your coins. These tend to fall into 2 categories: high risk pairs, and marketing promotions. Like anything in crypto, your stomach for risk and ability to research the underlying market are key to making money in these sorts of farms.

Many times you might find that a high interest rate is short-lived and that if you stake and leave your tokens there, after a few months, the rate has gone down or the farm has ended. Other times, you will find that thought the rate is high, you're still losing out due to price reductions in the staked tokens. If you're earning 1% per day but your tokens are dumping at a greater rate, then you're losing money, and may find that you're locked into a farm that you can't leave until the damage is done.

The long and short of it is to do your own research, look for large amounts of existing liquidity, and choose your tokens wisely.

 

There's a lot to unpack in the world of staking and impermanent loss, and this post has just scratched the surface. If you're interested in learning more, please like and comment below and we'll post more helpful articles! 

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Crypto For Monkes
Crypto For Monkes

This blog series is intended for those of us who started their crypto journey via DAG coins, such as Banano and Nano. These coins are a fantastic onramp to crypto, but they inevitably lead into more complex crypto topics, such as wrapping coins (wBan), using wallets such as Metamask and Trust Wallet, and navigating the Ethereum, Binance Smart Chain, and Polygon networks. If you're new to all this or have no idea what any of the above means, then you've come to the right place!

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