Impermanent Loss Explained
Impermanent loss (IL) is the most misunderstood concept in DeFi. It's the hidden cost of providing liquidity that many LPs overlook until too late.
What is Impermanent Loss?
Impermanent loss is the difference between:
- Value if you simply held your tokens
- Value of your LP position
It occurs whenever the price ratio of pooled tokens changes from when you deposited.
Why Does It Happen?
AMM pools must rebalance to maintain equal value:
- If ETH price rises, arbitrageurs buy ETH from pool
- Pool ends up with less ETH, more stablecoins
- You now have less of the appreciating asset
- Result: You underperform vs. just holding
If prices return to original ratio, the loss disappears. It only becomes "permanent" when you withdraw at different prices.
Impermanent Loss Chart
| Price Change | Impermanent Loss |
|---|---|
| 1.25x (25% up or down) | 0.6% |
| 1.5x (50% change) | 2.0% |
| 2x (100% change) | 5.7% |
| 3x (200% change) | 13.4% |
| 4x (300% change) | 20.0% |
| 5x (400% change) | 25.5% |
IL happens whether price goes up or down. A 50% drop causes the same IL as a 100% gain (2x). Any price divergence creates IL.
Calculating Impermanent Loss
The formula for IL:
- IL = 2 * sqrt(price_ratio) / (1 + price_ratio) - 1
- Or use online IL calculators
Example Calculation
You deposit $5000 ETH + $5000 USDC ($10,000 total)
ETH doubles in price:
- If you held: $10,000 ETH + $5,000 USDC = $15,000
- In LP position: Pool rebalanced to ~$7,071 ETH + $7,071 USDC = $14,142
- IL: $15,000 - $14,142 = $858 (5.7%)
When IL Matters Most
- Volatile pairs - ETH/random altcoin
- Strong price moves - Bull/bear markets
- Low fee pools - Fees don't offset IL
- Short time horizons - Less time to earn fees
When IL Matters Less
- Stable pairs - USDC/USDT has minimal IL
- Correlated assets - ETH/stETH move together
- High volume pools - Fees can exceed IL
- Long time horizons - More fees accumulated
LP is profitable when: Trading Fees Earned > Impermanent Loss. High volume pools with small price movements are ideal.
Strategies to Minimize IL
1. Choose Stable Pairs
- USDC/USDT - Negligible IL
- ETH/stETH - Same asset, different forms
- BTC/wBTC - Wrapped versions
2. Use Concentrated Liquidity Wisely
- Uniswap v3 amplifies both fees AND IL
- Narrow range = more fees but more IL risk
- Wide range = less of both
3. Time Your Entry/Exit
- Enter during stable periods
- Exit when prices return near entry
- Avoid adding during high volatility
IL vs. Trading Fees
The key question: Do fees cover IL?
| Scenario | Result |
|---|---|
| Fees > IL | Profitable LP position |
| Fees = IL | Break even (same as holding) |
| Fees < IL | Would have been better just holding |
Many LPs focus only on APY without considering IL. A 50% APY means nothing if you lose 60% to impermanent loss. Always factor in both.