What Is Impermanent Loss? How It Works, and How to Avoid It
DeFi makes you the market maker. Provide liquidity, earn fees, farm rewards—sounds like passive income, right? Not quite. Hidden beneath the surface is impermanent loss, a quirk of AMMs that quietly eats into returns. Every liquidity provider faces it, yet many misunderstand it. This is the straight talk: what it is, how it works, and how you protect your stack.
What Is Impermanent Loss?
Impermanent loss happens when the value of your tokens drops after you add them to a liquidity pool, compared to simply holding them. It’s caused by a change in the price ratio between the two assets you deposit. When that happens, the pool rebalances your share, and you may withdraw less total value than you would have had by just holding.
The bigger the price swing, the larger the loss for you as a liquidity provider.
Why Impermanent Loss Matters
Impermanent loss matters because it directly affects how much money you walk away with after providing liquidity. Even if prices go up, your returns can be lower than if you simply held your tokens.
This risk often surprises new liquidity providers. And it’s not rare: in volatile pools, impermanent loss can easily offset any profits from trading fees. In extreme cases, it can wipe out your gains entirely. If you don’t factor in this risk, your DeFi strategy might look profitable—until you withdraw and realize you’ve lost money.
Why It’s Called ‘Impermanent’
It’s called “impermanent” because the loss is only realized when you withdraw. The loss is unrealized (on paper) as long as you keep your funds in the pool. If token prices return to their original ratio, the loss disappears. But if you pull out while the ratio is still off, the loss becomes permanent.
So the name can be misleading—in practice, many users lock in losses when exiting a pool during price volatility.
How Impermanent Loss Happens: Step by Step
Let’s walk through what actually happens when impermanent loss kicks in.
You deposit into a liquidity pool—say, 1 ETH and 100 DAI—at equal value. That’s called providing liquidity, and the pool now holds your deposited assets. You own a share of the pool, not the exact tokens.
Now, the price of ETH shoots up. Suddenly, 1 ETH is worth 400 DAI. The price ratio has changed—and here’s where it gets interesting.
To maintain balance, the automated market maker (AMM) adjusts the pool’s contents using the constant product market maker model (x × y=k). This formula means the amount of one token (x) multiplied by the amount of the other token (y) must always equal a constant (k). If the price ratio changes, the pool automatically shifts its balance to preserve that equation. AMMs doesn’t ‘know’ the real-world price, so arbitrage traders step in, swapping tokens until the pool aligns with the market.
When you withdraw, your initial deposit of 1 ETH and 100 DAI is now something like 0.5 ETH and 200 DAI. Same total value? Not quite.
If you had just held your tokens, you’d have more. The pool ratio changed, and now your assets are worth less than HODLing. That gap is an impermanent loss, and it hits every time the market price drifts too far from where you started.
Impermanent Loss Estimation
The size of your impermanent loss depends on how much the price ratio changes between your two assets. The bigger the swing, the more you lose, compared to just holding.
And yes, the loss is real once you pull funds out of the liquidity pool. At that point, it becomes a realized loss on withdrawal, because the rebalanced tokens you receive are worth less in dollar terms than simply holding.
Use the Formula (or a Calculator)
The standard formula for impermanent loss estimation is based on the price ratio between tokens. It’s not linear: a 2× price change results in roughly 5.7% loss, while a 4× shift brings around 20% loss. You can plug the ratio into an online impermanent loss calculator to get the exact number.
Here’s the rough guide:
- 1.5× price change → ~2% loss
- 2× → ~5.7% loss
- 3× → ~13.4% loss
- 4× → ~20% loss
This assumes a 50/50 pool ratio, which most AMMs use. Other pool types may vary.
Watch the Dollar Value
Remember, this is a loss in dollar value. Your assets in the pool change form—you get more of the falling token, less of the rising one. Even if the total token count looks good, the value may not be. That’s the sting.
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Examples of Impermanent Loss
In the previous section, we broke down how impermanent loss happens and showed how a simple price change can eat into your gains. Now let’s see how that plays out with real pools.
In stable pairs like DAI/USDC, impermanent loss is minimal. The price ratio stays tight, so your initial deposit and dollar value hold steady. These pools are popular among cautious liquidity providers because the correlation between assets reduces the risk of heavy divergence.
In a volatile pair like ETH/ALTCOIN, prices often diverge fast. As your deposited assets rebalance, you end up with more of the loser and less of the gainer. That’s the hidden cost.
The UST/LUNA collapse
In May 2022, the UST/LUNA pool imploded. LUNA’s price collapsed, and liquidity providers were left holding nearly worthless tokens. Many saw losses of 99% or more in dollar value. The pool couldn’t protect them: once the assets in the pool collapsed, the impermanent loss became irreversible.
This shows just how brutal price divergence can be in high-risk pairs.
Liquidity Pool Impermanent Loss and Its Impact on Yield Farming
When you join a liquidity pool, you’re not just earning trading fees. You’re taking on price risk. That matters a lot in yield farming, where returns often look higher than they really are.
Here’s why: yield farming stacks extra rewards—like governance tokens—on top of your fee cut. That sounds great. But if the price ratio between your deposited assets shifts too much, your impermanent loss can erase those gains. You’re left with fewer tokens of the winner, and more of the one that underperformed.
Even with high trading fees (say, 0.3% per trade on AMMs like Uniswap), many liquidity providers still end up with lower dollar value than if they’d just held their tokens. Pools often promote juicy yields by showing the fee APR (annual percentage rate from trading fees). But those figures are just the gross income from swaps. They don’t factor in how impermanent loss can quietly reduce your real return.
And that’s the catch: yield farming doesn’t remove impermanent loss, it only tries to outpace it. Sometimes it works. Other times, especially in volatile markets, the loss wins. A 2021 study found that in 74% of Uniswap v3 pools, impermanent loss outweighed fees earned.
If you’re farming without tracking the market price, trading volume, and token behavior, you’re not earning yield, but gambling with your capital.
Factors Affecting Impermanent Loss
Not all liquidity pools are created equal, and neither is the risk. Several factors shape how much impermanent loss you’ll face as a liquidity provider.
1. Price Volatility
The bigger the price fluctuations between your paired assets, the more the price ratio shifts, and the larger your loss. Stablecoin pairs like USDC/DAI barely move, so loss is minimal. In contrast, volatile combos like ETH/MEMECOIN swing hard and often.
2. Market Conditions
Market volatility spikes during news events, crashes, or rallies. These moments can quickly widen gaps between asset prices, triggering serious rebalancing in your pool. If you’re not watching the market price, you may not react in time.
3. Pool Structure
The total liquidity, initial deposit, and size of the pool all matter. In high volume pools, trades happen constantly, which can generate more trading fees, helping to offset impermanent loss. But in smaller or low-volume pools, fees may not be enough.
Some protocols now use concentrated liquidity models, where LPs focus their funds within a set price band. The upside is higher fee income, but the downside is bigger impermanent loss once prices move out of range.
4. External Factors
Things like arbitrage traders, project news, or token depegs can distort values fast. Always understand what drives your crypto assets before you add them to a pool.
Impermanent Loss and Volatility in the Crypto Market
Impermanent loss occurs as prices drift—and the bigger the drift, the worse it gets. A calm environment means smaller shifts, but high market volatility makes every move riskier.
Here’s why: in DeFi liquidity pools, the initial price of your tokens sets the baseline. As markets swing, the deposited assets change automatically, because that’s how liquidity pools work. You might walk away with more of the weaker token and less of the stronger one.
Even with high trading volumes, volatility can outweigh the trading fees generated. And in extreme moves, what looked like a minor temporary loss can become permanent the moment you withdraw.
Volatility doesn’t just test patience. It magnifies the risk of impermanent loss. If you’re active in decentralized exchanges, watching both price trends and market conditions is the only way to protect your position.
How to Reduce or Avoid Impermanent Loss
Smart liquidity provision isn’t about chasing every pool. It’s about lowering the impermanent loss risk.
One approach is sticking with stable assets. They move less, which means fewer rebalances. Stablecoin-focused platforms such as Curve Finance are popular for minimizing exposure.
Another is using decentralized finance platforms that design pools to soften associated risks, like pairing coins whose prices track each other closely.
Diversification helps, too. Spreading into multiple pools prevents one bad bet from ruining your portfolio. Advanced AMMs such as Balancer let providers set different token ratios, which can shift how impermanent loss plays out.
Some use single-sided liquidity, depositing just one token instead of a pair to reduce exposure. On platforms like Uniswap v3, you can also set a range order by providing liquidity only within a chosen price band. Always do your own research—every specific pool has different trade-offs.
Loss never disappears, but you can reduce exposure. The more carefully you choose, the more likely your potential earnings outweigh the potential risks.
Final Thoughts
Impermanent loss isn’t a flaw. It’s how automated market makers balance prices. If you provide liquidity, you accept potential losses in exchange for fees or farming rewards. The trick is not to fear it but to account for it. Choose pools carefully, watch your positions, and understand the math before committing crypto assets.
FAQ
Can you recover from impermanent loss?
Yes, recovery is possible, but only if prices return to their original ratio while your liquidity remains in the pool. In that case, the loss disappears. If you withdraw while prices are still off, the loss locks in permanently. Some DeFi protocols experimented with coverage programs, but those depend on the platform’s design and long-term health. In practice, the best “recovery” comes from trading fees or incentives that outweigh the loss while you stay invested.
Is impermanent loss always a bad thing for liquidity providers?
Not always. In many cases, fee income or farming rewards outweigh the value lost from rebalancing.
Some providers deliberately choose pools with high trading volume, expecting fee revenue to cover the downside. Others join correlated or stablecoin pools to keep loss minimal. Impermanent loss is “bad” only if it exceeds the benefits.
For savvy providers, it’s just another factor in the equation: a cost that can be justified by higher yield.
How do I calculate impermanent loss before providing liquidity?
You calculate it by comparing the value of holding versus pooling at different price changes. The formula isn’t linear: a doubling in price creates about a 5–6% loss, while a 4× change results in around 20%. Tools online let you plug in price ratios to estimate the impact.
The key is to run the numbers before you commit funds. If projected fee income and rewards don’t exceed the loss, the pool isn’t worth it.
Does impermanent loss still occur in stablecoin pairs?
Yes, though usually at a very small scale. Both tokens track the dollar closely, so the price ratio hardly shifts. That makes losses negligible under normal conditions.
The danger comes from depeg events, when one stablecoin drifts away from its peg. In those events, the pool rebalances heavily into the weaker token, leaving providers exposed. So while stablecoin pools are safer than volatile pairs, they still carry some potential risks.
Disclaimer: Please note that the contents of this article are not financial or investing advice. The information provided in this article is the author’s opinion only and should not be considered as offering trading or investing recommendations. We do not make any warranties about the completeness, reliability and accuracy of this information. The cryptocurrency market suffers from high volatility and occasional arbitrary movements. Any investor, trader, or regular crypto users should research multiple viewpoints and be familiar with all local regulations before committing to an investment.
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