Impermanent Loss Explained

The name is badly chosen. The loss becomes permanent the moment you withdraw, and it is the main reason liquidity provision underperforms expectations.

Where the loss comes from

A constant-product automated market maker holds two assets and keeps their product constant:

When the external market price moves, arbitrage traders rebalance the pool until its internal price matches. They do this by buying the asset that has become cheap in the pool and selling the one that has become expensive — and they keep the difference.

The consequence for a liquidity provider is mechanical: the pool always ends up holding more of the asset that fell and less of the asset that rose. You are systematically sold out of the winner and topped up with the loser. That divergence from simply holding both is impermanent loss.

How large it gets

Two features are worth noting. The loss is symmetric: a halving produces the same percentage loss as a doubling, because only the ratio matters. And it is non-linear: modest divergence costs little, while large divergence costs a great deal. A pool of two assets that move together closely — two stablecoins, or a token and its staked derivative — experiences very little.

Note also that impermanent loss is relative, not absolute. If both assets rise, you can be up in absolute terms and still worse off than if you had held them. That is the comparison that matters for deciding whether to provide liquidity at all.

When the fees make it worthwhile

Liquidity providers earn a cut of every swap, typically 0.05–1 % depending on the pool. The question is whether that revenue exceeds the divergence cost.

Fee income scales with trading volume relative to pool size. A pool with high volume and low total liquidity pays its providers well; a large pool with little trading does not. The metric to look at is daily volume divided by total value locked — a ratio above roughly 0.5 suggests meaningful fee generation, though the required level depends on how volatile the pair is.

This is also why stablecoin pairs are the most reliable liquidity provision: divergence is minimal, so almost all fee income is profit. Volatile pairs can work, but they need genuinely high volume to compensate, and the compensation is uncertain while the divergence is not.

Practical approaches

• Correlated pairs. Two stablecoins, or an asset and its wrapped or staked version, minimise divergence structurally.
• Concentrated liquidity. Newer AMM designs let you supply liquidity only within a price range, which multiplies fee income but also concentrates impermanent loss if the price leaves the range — where you end up holding entirely the weaker asset.
• Watch the incentives. Pools advertising very high APY are usually paying in emitted governance tokens whose price is falling. Compute the return assuming the token loses most of its value.
• Count the gas. On expensive networks, entering and exiting a position can cost more than the fees earned on a small deposit.
• Remember the tax. In many jurisdictions entering and exiting a pool is a disposal, and rewards are income. See our tax guide.