In the world of cryptocurrency, there are a lot of technical terms that can be confusing for those who are new to the space. One such term is "impermanent loss." Impermanent loss occurs when the price of an asset you're holding falls below the price at which you purchased it. In this article, we'll explain what impermanent loss is and how it can impact your crypto portfolio.
What is Impermanent Loss?
Impermanent loss is a type of risk that's inherent in cryptocurrency trading. It occurs when the price of an asset you're holding falls below the price at which you purchased it. For example, let's say you bought 1 ETH for $200. The price of ETH then rose to $250, so you sold it. However, the price of ETH then fell to $225. This means that you incurred an impermanent loss of $25.
How Does Impermanent Loss Occur?
Impermanent loss can occur for a variety of reasons. The most common reason is due to market volatility. Cryptocurrencies are notoriously volatile, which means that their prices can fluctuate wildly in a short period of time. This makes them susceptible to sudden drops in price, which can lead to losses for traders who are unprepared for such fluctuations.
Another common cause of impermanent loss is poor risk management. When traders don't properly manage their risks, they expose themselves to more volatility and larger losses. For example, if a trader has too much exposure to a single cryptocurrency, they could suffer significant losses if that cryptocurrency suddenly drops in value.
Finally, an impermanent loss can also be caused by changes in tradable pairs. For example, if the price of BTC falls against USD but rises against EUR, traders who are long BTC/USD will incur an impermanent loss even though BTC/EUR may have risen in value. Changes in tradable pairs can also lead to what's known as " divergence risk ." This is when the prices of two assets begin to move in opposite directions even though they're paired together. Divergence risk can lead to large losses if not managed properly.
Impermanent Loss and You
As a trader or investor, it's important to be aware of the risks inherent in the cryptocurrency market. Impermanent loss is one such risk that every trader should understand before entering into any trades or investments. By being aware of this risk and managing it properly, you can help protect your portfolio from major losses.