Guide · Crypto
Impermanent Loss Explained: The Hidden Risk of Liquidity Pools
Providing liquidity to a decentralised exchange can earn trading fees, but it also exposes you to impermanent loss—a systematic drag that automatically increases when one token moves strongly relative to the other.
What is impermanent loss and why does it happen?
Automated Market Makers (AMMs) like Uniswap maintain a constant ratio between two tokens in a liquidity pool using the formula x × y = k, where x and y are the quantities of each token and k is a constant. When external market prices change, arbitrageurs trade against the pool to bring it back into alignment with the wider market. This rebalancing means the pool ends up holding less of the token that rose in price (because arbitrageurs bought it) and more of the token that fell (because they sold it).
The result is that as a liquidity provider, you end up with fewer of the winning token than you would if you had simply held both tokens in your wallet. This difference is impermanent loss. It is called “impermanent” because if prices return to the original ratio, the loss disappears entirely. In practice, prices rarely return to exactly the same ratio.
Impermanent loss in numbers: ETH/USDC example
Suppose you deposit 1 ETH ($2,000) and $2,000 USDC into a 50/50 ETH/USDC pool, for a total deposit of $4,000. ETH's price then changes. The table shows what happens to the pool value versus simply holding the same assets.
| ETH price | Pool value | HODL value | IL ($) | IL (%) |
|---|---|---|---|---|
| $1,000 (−50%) | $2,828 | $3,000 | −$172 | −5.7% |
| $2,000 (no change) | $4,000 | $4,000 | $0 | 0% |
| $3,000 (+50%) | $4,899 | $5,000 | −$101 | −2.0% |
| $4,000 (2×) | $5,657 | $6,000 | −$343 | −5.7% |
| $10,000 (5×) | $8,944 | $12,000 | −$3,056 | −25.5% |
Notice that IL is symmetric: a 50% drop causes the same ~5.7% loss as a 2× increase. The loss grows sharply at extreme price movements. A 5× increase in ETH price leaves you 25.5% worse off than if you had simply held.
When impermanent loss matters less
Stablecoin-to-stablecoin pools (USDC/USDT, DAI/USDC) have minimal price divergence because both tokens are pegged to $1. The AMM barely rebalances, and the IL incurred is negligible. These pools are lower-risk entry points for liquidity provision, though the fees earned per dollar of volume are also lower.
Concentrated liquidity (introduced in Uniswap v3) allows liquidity providers to deploy capital within a specific price range rather than across all possible prices. This dramatically increases capital efficiency—you earn far more fees on the same amount of capital within your chosen range. However, concentrated liquidity also amplifies impermanent loss: if the price moves outside your range, you stop earning fees entirely and your position converts fully into the cheaper token.
Fee income can offset impermanent loss in high-volume pools. A pool trading $50 million per day at 0.3% generates $150,000 in daily fees distributed among liquidity providers. If your share is large enough and the price movement is small, fees can more than compensate for IL. The calculation requires modelling both the expected fee income and the expected IL simultaneously—the impermanent loss calculator lets you do exactly this.
Frequently asked questions
When does impermanent loss become permanent?
Impermanent loss becomes permanent when you withdraw your liquidity at a time when the price ratio between the two tokens differs from when you deposited. If you deposit when ETH is $2,000 and withdraw when ETH is $4,000, the loss is locked in. The 'impermanent' label is technically accurate—the loss disappears if prices return to the exact entry ratio—but in practice, token prices rarely return to a precise earlier level, making the loss effectively permanent for most liquidity providers.
How are AMM trading fees related to impermanent loss?
Every time a trader swaps tokens through a liquidity pool, liquidity providers earn a share of the trading fee (typically 0.05%, 0.3%, or 1% depending on the Uniswap pool tier). These fees accumulate in the pool and increase the value of your position over time. Whether providing liquidity is profitable depends entirely on whether the fees earned exceed the impermanent loss incurred. High-volume pools with stable price ratios (like ETH/USDC during sideways markets) can be profitable; low-volume pools with diverging prices almost always lose.
Are stablecoin pools subject to impermanent loss?
Technically yes, but the loss is minimal in practice. A USDC/USDT pool has almost no price divergence because both tokens are pegged to $1. The AMM rebalances very little, and the fees earned easily cover any tiny impermanent loss. This is why stablecoin pools are popular for lower-risk yield: you sacrifice some of the higher fee income from volatile pairs in exchange for near-zero impermanent loss.
How do I calculate impermanent loss?
The impermanent loss formula is: IL = 2 × √(price ratio) ÷ (1 + price ratio) − 1, where price ratio is the current price of the volatile token divided by its price at deposit. A 2× price increase gives IL of approximately −5.7%. A 5× increase gives −25.5%. A 10× increase gives −42.5%. The loss is symmetric: a price halving gives approximately the same IL as a doubling. Use the impermanent loss calculator to model any price change scenario.