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Providing Liquidity: Understanding Impermanent Loss (ELI5).
The start of 2021 was also the beginning for the Binance Smart Chain ecosystem to boom that within just the first quarter of the year, we have seen BSC projects growing massively along with its native token - mentioning BAKE and CAKE tokens.
These Automated Market Makers and Decentralize Exchanges under Binance Smart Chain ecosystem are giving its users/investors a huge opportunities to farm a so-called "BSC Gems" or a new tokens that are likely to explode in the future.
This new "gems" can be bought in their trading platforms or can be earn simply by Providing Liquidity in an exchange's pool.
When you provide liquidity in a pool, you will have your LP tokens generated from your deposited assets and you can stake it for you to farm the tokens you wanted to accumulate.
When you stake those LP tokens, that will generate you a possible passive income and it's up to you if you want to sell those generated tokens or hold it till it reached its potential price in the future. However, things can be uncertain in the long run because Impermanent Loss can happen anytime when you Provide Liquidity.
Impermanent Loss is the change of the quantity/price of your deposited assets when you have provided liquidity in a pool. The bigger the change there is, the more you are to experience this impermanent loss, whether the price of the token goes up or down, it can happen.
Let me explain it as simple as I can:
Let's say that you have found a token with a very huge potential for 100x return in the near future and you wanted to farm and accumulate it as possible as you can.
Then you found out that you can farm it in Pancakeswap DEX by staking BCH and USDT LP tokens.
The name of the token is BCHJR, for example.
For you to farm the token, you would be needing a BCH and a USDT to provide liquidity in the pool and to have the LP Tokens from it.
So, you bought 1 BCH with a price of $1,000, and with that, you also need 1,000 USDT to match the amount of BCH you have for you to provide the liquidity.
1 BCH = $1,000
1,000 = $,1000
And you can just simply add it in the pool then you will have your LP tokens and stake.
When you have staked your LP Tokens to the staking you want, you can now let it run and make you generate or earn BCHJR for you to hold.
But how does impermanent loss takes effect here?
Since cryptocurrencies are volatile, and BCH is no exception, its price can change every second and that can affect to the liquidity you provided.
But, impermanent loss will only take effects if you remove your liquidity in the pool.
Your 1 BCH, that was worth $1,000 at the time you deposited it, changes and the price of 1 BCH is now $2,000 each.
Now, you wanted to remove the liquidity you provided while the price of BCH is at $2,000.
Because of the change, and the price of $1,000 worth of BCH you deposited you will only receive 0.5 BCH but you will have 1,500 USDT. The quantity of your BCH will decrease but a USDT will be added.
And if you think of it, 0.5 BCH is equal to $1,000 plus 1,500 USDT, a total of $2,500.
Do you think you are at loss or in profit? Well, maybe it's a yes and a no.
Yes, because you have gained additional 500 USDT from the time you deposited your assets till now.
No, because if you have just hold your BCH and USDT, your 1 BCH that should be worth $2,000 and your 1,000 USDT should make you have a total of $3,000 - and that's the cause of impermanent loss.