What is impermanent loss?

What is impermanent loss?

Impermanent loss (IL) is the value difference between:

• Putting crypto into a liquidity pool
• Simply holding that same crypto in your wallet (HODL)

If liquidity providing leaves you with less value than simply holding, you are dealing with impermanent loss.

Important: this is not a “loss” in the classic sense. Your total value can still increase. Impermanent loss only means that you are relatively worse off than if you had done nothing. The difference is caused by a changing price ratio between the two tokens in the pool. The further that ratio moves away from the moment you entered, the larger the difference becomes.

Key takeaways

• Impermanent loss (IL) is the return difference between liquidity providing and simply HODLing.
• IL is caused by changes in the price ratio between two tokens in a liquidity pool.
• It is called “impermanent” because the difference only becomes final when you remove your liquidity from the pool.
• IL occurs during both rising and falling prices and does not grow linearly, but accelerates during large price movements.
• Trading fees and rewards can offset or even exceed impermanent loss.

Why is it called “impermanent”?

As long as you do not remove your liquidity from the pool, the difference is not final. If prices return exactly to their original level, the impermanent loss disappears automatically.

But: the moment you exit while the price ratio has changed, the difference becomes permanent. That is often when people first realize what actually happened.

How AMMs cause this (without technical jargon)

Liquidity pools work through automated market makers (AMMs). Instead of matching buyers and sellers, a mathematical formula determines the price based on the ratio between two tokens.

In most pools, this is a 50/50 split in dollar value.

As soon as someone buys or sells a token:

• The balance in the pool changes
• The price in the pool shifts
• Arbitrage traders jump in

These arbitrage traders make sure the pool price stays aligned with the market price. This mechanism ensures that you, as a liquidity provider, automatically:

• Receive more of the asset that has relatively decreased in price (or increased less)
• Receive less of the asset that has become relatively stronger

That relative difference compared to HODLing is impermanent loss.

Example of impermanent loss

Suppose you provide 1 ETH and 100 USDC to a pool. ETH is priced at $100 at that moment. Your total deposit is $200.

The pool contains a total of:

• 10 ETH
• 1,000 USDC

You own 10% of the pool.

A few weeks later, ETH is trading at $400. The pool does not simply hold onto your ETH. Traders buy ETH from the pool as long as it is cheaper than on the market and add USDC back into the pool.

After this arbitrage, the pool roughly looks like this (rounded):

• ~5 ETH
• ~2,000 USDC

If you now remove your liquidity, you receive your 10%:

• ~0.5 ETH
• ~200 USDC

Total value:

• 0.5 ETH x $400 = $200
• 200 USDC = $200

Total: $400

So your value has doubled.

But if you had done nothing and simply held 1 ETH + 100 USDC:

• 1 ETH x $400 = $400
• 100 USDC = $100

Total: $500

The $100 difference is impermanent loss.

This does not mean you lost $100. You actually made $200 in profit. Impermanent loss only tells you that you earned $100 less in returns compared to HODLing.

Do fees affect impermanent loss?

The previous example assumed zero trading fees. In practice, as a liquidity provider you earn a portion of every swap. With enough volume, this can add up significantly.

Sometimes those fees are:

• Enough to fully offset impermanent loss
• Or even enough to outperform HODLing

That is why you should never look at impermanent loss in isolation. It is always about the balance between impermanent loss and returns.

Does impermanent loss only happen during downtrends?

No. A common misconception is that impermanent loss only occurs when prices go down. That is not true.

The only thing that matters is how much the price ratio changes. Whether ETH drops from $100 to $50 or rises to $400, impermanent loss occurs in both cases. The larger the deviation from the original price, the larger the difference compared to a HODL strategy.

How fast does impermanent loss increase?

Impermanent loss does not grow linearly. The further the price moves, the faster the difference increases.

For a standard 50/50 pool without fees, it looks roughly like this:

With extremely volatile altcoins, this can grow significantly, even when prices are rising.

The impermanent loss formula

For a standard 50/50 constant product AMM:

Impermanent loss = (2 × √price ratio) / (1 + price ratio) - 1

Where the price ratio = New price / old price

In practice, most people use an online calculator. It is faster, more accurate, and less error-prone.

Why do people still choose liquidity pools?

Because liquidity providing is about more than just price movements. You can earn from:

• Trading fees
• Yield farming rewards
• Sometimes airdrops or governance tokens

With sufficient volume and good incentives, liquidity providing can be more profitable than HODLing, even with impermanent loss.

When is impermanent loss especially risky?

The risk is particularly high with:

• New or hype-driven altcoins
• Crypto pairs with low liquidity
• AMMs without a proven track record
• Pools where you may need to exit quickly

Going all-in on a single pool also significantly increases risk.

How can you reduce impermanent loss risk?

You cannot eliminate impermanent loss, but you can manage it:

• Choose lower volatility: ETH/stablecoin is often more stable than alt/alt
• Stablecoin pairs: minimal impermanent loss, but watch out for de-pegs
• Alternative pool structures: models like 80/20 or 95/5 reduce risk
• Start small: test with an amount you can afford to lose
• Spread your liquidity across multiple pools
• Be skeptical of extremely high APYs: high returns almost always mean extra risk

Is there protection against impermanent loss?

Yes, some DeFi protocols offer protection against impermanent loss. This often works like a form of insurance where part of the loss is compensated, usually depending on how long your liquidity stays in the pool.

There are downsides as well:

• Less flexibility due to lock-ups
• Lower returns compared to regular pools
• Extra conditions that are not always in your favor

So do not see impermanent loss protection as a free safety net, but as a conscious trade-off between returns, flexibility, and security.

Final thoughts

Impermanent loss is not a mistake or a hidden cost, but an inherent mechanism of liquidity pools that use automated market makers. It does not mean you lose money, but that your returns differ from simply holding. Whether liquidity providing is attractive therefore never depends on impermanent loss alone, but always on the full picture: price movements, fees, incentives, and risks. Those who understand this well and consciously choose suitable pools can manage impermanent loss and use liquidity providing strategically instead of being caught off guard.