What is impermanent loss & how it affects liquidity providers
Impermanent loss (IL) is the temporary loss of value that liquidity providers (LPs) experience when the price of tokens in a liquidity pool changes compared to simply holding them. It occurs in automated market maker (AMM) decentralized exchanges (DEXs) like Uniswap, SushiSwap, and PancakeSwap.
This loss happens because the AMM rebalances token ratios in a liquidity pool, which can cause LPs to end up with more of the token that depreciated and less of the one that gained value.
Example of impermanent loss
- You deposit 1 ETH ($2,000) and 2,000 USDT ($2,000) into a 50/50 liquidity pool.
- The pool initially holds 10 ETH and 20,000 USDT.
- If ETH's price doubles to $4,000, arbitrage traders rebalance the pool.
- Your share of the pool now contains ~0.71 ETH and 2,828 USDT (still worth ~$4,000, but less ETH than before).
- Had you just held 1 ETH + 2,000 USDT, you would have $6,000 instead.
- Your impermanent loss is $2,000.
If prices return to the original level, the loss disappears, hence "impermanent", but if you withdraw, the loss becomes permanent.
How impermanent loss happens
- You provide liquidity to a pool (e.g., ETH/USDT 50/50 split).
- Token prices change, causing arbitrage traders to balance the pool.
- The AMM adjusts your token share, leaving you with a different ratio.
- If you withdraw, you may receive fewer valuable tokens, resulting in impermanent loss.
- The larger the price change, the greater the impermanent loss.
How to calculate impermanent loss
The formula for impermanent loss:
IL = 2 × price ratio / (1 + price ratio) - 1
where price ratio = new price / initial price.
| Price Change | Impermanent Loss |
|---|---|
| +5% | 0.23% |
| +20% | 2.0% |
| +50% | 5.7% |
| +100% (2x) | 19.4% |
| +300% (4x) | 41.4% |
The more the price diverges, the bigger the loss.
How to reduce impermanent loss
- Choose stablecoin pairs (USDT/USDC, DAI/USDC) – Low volatility means minimal loss.
- Select high-fee pools – Earning trading fees can offset IL.
- Use impermanent loss protection – Some platforms (like Bancor) offer protection over time.
- Diversify liquidity pools – Avoid putting all funds in one volatile pool.
- Use Layer 2 scaling solutions – Lower transaction fees help offset losses.
Impermanent loss vs. permanent loss
| Feature | Impermanent Loss | Permanent Loss |
|---|---|---|
| When it happens | When token prices diverge | When LP withdraws before price returns |
| Can be reversed? | Yes, if prices return to initial levels | No, once liquidity is withdrawn |
| Offset by fees? | Yes, in high-volume pools | No |
Impermanent loss is only realized if you withdraw liquidity before prices rebalance.