Risk of Impermanent Losses
Liquidity farms provide high yield because liquidity providers are exposing themselves to price volatility risks by providing liquidity. Liquidity providers need to earn rewards to justify taking these risks.
Rewards are available in the form of sharing transaction fees. However this is not attractive enough to attract liquidity to new tokens with smaller liquidity pools. Therefore, Supernovas provide these rewards through liquidity yield farming.
Risk of Impermanent Losses
Price volatility can result in the liquidity provider taking Impermanent Losses. The losses are called "Impermanent" because the losses occur if the price moves up or down, but if the price then returns to the initial level then the losses are recouped. So its only a real loss if the liquidity is withdrawn at a different price level to when the liquidity was initially deposited.
If the price of the underlying tokens increased, then the liquidity provider may still have earned a profit, but the profit would have been less than if the tokens were not deposited into the liquidity pool.
As a rule of thumb, the following table shows the relationship between price volatility and Impermanent Losses:
- Price increase of 2x underlying tokens result in 5.7% loss
- Price increase of 5x result in in 25.5% loss
- Price increase of 10x result in in 45.5% loss
The inverse is also true:
- Price fall of 50% underlying tokens result in 5.7% loss
- Price increase of 80% result in in 25.5% loss
- Price increase of 90% result in in 45.5% loss
Note that these are cumulative, so 2x or 200% then 5.7% loss out of this increase, so net gain of 188.6%
These price volatilities are extreme, but crypto markets and tokens can and experience these extreme price changes.
These price swings can actually occur quite often, especially when the liquidity pool size is small.
Binance Academy provide an excellent tutorial here https://academy.binance.com/en/articles/impermanent-loss-explained