Glossary
Impermanent loss
Impermanent loss is the shortfall a liquidity provider suffers when the prices of the tokens deposited in an automated market maker pool diverge, compared with simply holding the same tokens in a wallet. It becomes permanent when the provider withdraws.
Also called IL, Divergence loss, Liquidity provider loss, LP loss
See also
Impermanent loss is the main hidden risk of providing liquidity on a decentralized exchange. When you deposit two tokens in a liquidity pool, the pool constantly rebalances your share as traders buy and sell. If the price of one token moves a lot relative to the other, you end up with a mix worth less than if you had just kept the tokens. The loss is called “impermanent” because it disappears if prices return to where they were, but it becomes real as soon as you withdraw.
How it happens
Most automated market makers keep the product of the two reserves constant (x × y = k). When ETH rises on other markets, arbitrage traders buy the cheaper ETH from the pool until its price matches. The pool, and therefore you, ends up holding less ETH and more of the other token. You have effectively sold your ETH on the way up.
A worked example
You deposit 1 ETH and 2,000 USDC when ETH is worth $2,000: $4,000 in total. ETH then doubles to $4,000. Arbitrage leaves your share of the pool at about 0.707 ETH and 2,828 USDC, worth about $5,657. Had you simply held, you would have 1 ETH + 2,000 USDC = $6,000. The difference, about $343 or 5.7%, is the impermanent loss, before counting the trading fees you earned.
The loss grows with the price change, in either direction:
- price × 1.5 or ÷ 1.5: about 2.0%
- price × 2 or ÷ 2: about 5.7%
- price × 4 or ÷ 4: about 20%
Why it matters
Liquidity providers are paid with a share of trading fees and sometimes token rewards, as in yield farming. Those earnings only make sense if they exceed the impermanent loss. A pool showing a high yield can still lose money against holding when one token rallies or crashes.
How to reduce it
- Choose pairs that move together, such as two dollar stablecoins, or a token and its liquid staking version.
- Prefer pools with high, sustainable trading volume, where fees can compensate.
- Understand concentrated liquidity: it boosts fees but amplifies impermanent loss when the price leaves your range.
- Remember the other risks of DeFi, from smart contract bugs to fake pools. Our guide DeFi explained covers them.