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Step 1: Supplies & Equipment
100% wool is the best yarn to use. Feel free to experiment with other natural fibers. Synthetic fibers generally don't take dye very well.
You can use any powdered drink mix, but make sure it's unsweetened powdered drink mix. When you're buying Kool-Aid, look at the color of the glass Kool-Aid Man is holding - not the Man himself or the packet - to know what color the drink mix will be. A reference photo of yarns dyed with Kool-Aid is available from Knitty.com, here.
Most guidelines on dyeing with Kool-Aid will recommend 1 packet of Kool-Aid for every ounce of yarn. I usually use a lot more - here I have 3 packets of lemonade (yellow), and 4 of lemon-lime (green), for 4 ounces of yarn. This is overkill, by a little bit - but if you want vivid colors, you need a lot of Kool-Aid.
You'll also need a saucepan, a bowl, and a big spoon.
Step 2: Make a Yarn Ball & Get It Wet
Soak the ball in water. Squeeze it gently, if you need to - try to saturate it as completely as possible.
Step 3: Dye the First Color
Put some water in your pot, add the first round of Kool-Aid (3 packets of Lemonade/yellow, here), stir, and put the yarn in the pot. The perfect pot is one that's just big enough around to hold your ball of yarn, with a little room for it to move. Add enough water to cover - or mostly cover, depending on the depth of your pot - the yarn ball.
Step 4: Cook the Yarn
You may need to roll the yarn ball from time to time to keep it evenly covered by the water, depending on how it fits in your pan. If you do, be very gentle. Agitation at this point can cause the yarn to felt.
When the yarn has taken up all the color, the water will be almost clear. At that point, you're done with the first round of dyeing.
Once the water is clear, lift the yarn out of the pot with the spoon, let the excess water drain off, and set the yarn aside in the bowl while you prepare the next batch of dye.
(Note: Some colors of Kool-Aid have a milky look. If you're using one of those, the water will be white or cloudy, not clear, when the yarn has taken up all the dye.)
Step 5: Dye the Second Color
Put the yarn back in your pot, and continue to heat gently and stir as necessary. (You can see where my yarn ball has started to unroll, so I have to be very careful.)
Step 6: A Finishing Touch
This time, I'm not stirring it into the water. I'm sprinkling the powder directly onto the yarn ball, so it will have a more irregular pattern across the finished yarn.
Using the darker Kool-Aid tends to tone down the colors and make the finished product look a bit less - well, like Kool-Aid.
Step 7: Finishing
Pull the ball out and let it cool. Cleanup is easy - just dump the water and put your pot in the dishwasher.
Avoid the temptation to try to peek at your yarn too quickly - it stays hot!
Step 8: The Finished Product, and Notes
Unwind it into a skein, give it a good rinse, and let it dry.
You can play with this technique - I made the blue and green yarn by dyeing a ball, re-winding it into a ball from the other end, and dyeing it again.
If you want to have more white space towards the center, wind tighter. The dye won't penetrate as far if it's wound tighter.
Pressing on the ball (very gently, to avoid felting) helps the dye go deeper, but it's also more irregular. If you want a nice, smooth, fade, leave the ball alone as much as possible.
I hope you have fun!