Impermanent loss is the gap between what your tokens are worth inside a liquidity pool and what they would be worth if you had simply held them. It affects anyone who provides liquidity to an automated market maker (AMM), and it is the main reason a pool position can underperform even when fees look attractive.
What Impermanent Loss Is
When you deposit two tokens into a pool, you stop owning fixed amounts of each. You own a share of the pool, and the pool's mix of tokens changes as people trade. If the price of one token moves against the other, the pool ends up holding less of the token that went up and more of the one that went down.
The result is that your position is worth less than the same tokens held in a wallet. The loss is called impermanent because it shrinks back to zero if the price ratio returns to where it was when you deposited. If you withdraw while the ratio is different, the loss becomes permanent.
The loss is measured against holding. You can be in profit in dollar terms and still have impermanent loss, because holding would have made more.
Why AMMs Create This Effect
The classic AMM design, described in the Uniswap v2 whitepaper, uses a constant product formula: x multiplied by y equals k. Here x and y are the quantities of the two tokens in the pool. Every trade must leave the product unchanged, before fees.
The pool does not know the market price. It only knows its own balances. When the price of ETH rises on other exchanges, the pool's ETH is briefly cheap. Arbitrage traders buy ETH from the pool until its price matches the market. They take the token that rose and leave more of the other one behind.
That arbitrage is what keeps the pool's price accurate. It is also where the loss comes from. Liquidity providers are, in effect, selling the rising token on the way up and buying the falling token on the way down.
A Worked Example
You deposit 1 ETH and 2,000 USDC into a pool when ETH trades at 2,000 USDC. Your deposit is worth 4,000 USDC. ETH then doubles to 4,000 USDC.
- After arbitrage, your share of the pool is about 0.707 ETH and 2,828 USDC.
- Position value: about 5,657 USDC.
- Value if you had held 1 ETH and 2,000 USDC: 6,000 USDC.
- Difference: about 343 USDC, or 5.7%.
You still made money. You made about 5.7% less than you would have by holding, before counting fees earned.
How the Loss Scales
For a standard 50/50 constant product pool, the loss depends only on how far the price ratio has moved, not on the direction. A price that halves produces the same loss as a price that doubles.
- Price changes 1.25x: about 0.6% loss versus holding
- Price changes 1.5x: about 2.0%
- Price changes 2x: about 5.7%
- Price changes 3x: about 13.4%
- Price changes 4x: about 20.0%
- Price changes 5x: about 25.5%
These figures exclude trading fees. They also do not apply to pools with other designs, such as weighted pools or stablecoin curves.
Fees Versus Loss
Liquidity providers earn a cut of every trade. In Uniswap v2 the fee was 0.3% of each swap, shared across providers in proportion to their stake. Whether a position comes out ahead depends on whether the fees collected exceed the impermanent loss over the same period.
High trading volume relative to pool size is good for providers. Large one-way price moves are bad. A pool can show a high fee APR and still lose against holding if the price trends hard in one direction.
Concentrated Liquidity
Uniswap v3, launched in 2021, introduced concentrated liquidity. Providers pick a price range instead of covering every possible price. Within the range, their capital earns more fees per dollar.
The trade-off is sharper impermanent loss. A narrow range behaves like a larger position, so the same price move does more damage. If the price leaves the range, the position converts entirely into the weaker token and stops earning fees until the price comes back or the provider moves the range.
Ways to Reduce Exposure
- Correlated pairs: two stablecoins, or a token and its liquid staking version, have a ratio that moves very little. The remaining risk is that one of them loses its peg.
- Compare fees to expected movement: look at pool volume and liquidity, not only the headline APR.
- Wider ranges: on concentrated liquidity pools, a wider range reduces the effect of each price move at the cost of lower fee income.
- Time horizon: short deposits in volatile pairs have less time for fees to add up.
No pool design removes the risk fully. Designs that reduce it usually move the cost somewhere else, for example to token emissions or to a protocol reserve.
Common Mistakes
- Reading reward APR as profit without subtracting impermanent loss.
- Counting incentive tokens at today's price when their value may fall.
- Assuming the loss will reverse. It only reverses if the price ratio returns.
Nothing in this article is financial advice.
Key Points
- Impermanent loss is measured against holding, not against your deposit value.
- It grows with the size of the price move, in either direction.
- A 2x move costs about 5.7% in a standard 50/50 pool.
- Fees can offset it, and sometimes do not.
- Concentrated liquidity raises both fee income and loss.
Track on CoinMarketGuy
The DEX page lists active liquidity pools with their trading volume and liquidity, which are the two numbers that drive fee income. To follow the price of a token you have paired, open its coin page, for example the Ethereum price page or the Uniswap price page.