By Team SalaryCalculate · 9/11/2025
You've heard about yield farming and liquidity provision. The returns look attractive - sometimes 20%, 50%, or even 100% APY. But there's a hidden cost that many newcomers miss: impermanent loss.
Impermanent loss isn't actually a loss in the traditional sense. It's the difference between what you would have earned by simply holding your tokens versus what you earn by providing liquidity to a pool. Understanding this concept is crucial before diving into DeFi.
What Is Impermanent Loss?
Impermanent loss occurs when the price ratio of tokens in a liquidity pool changes after you've deposited them. The automated market maker (AMM) automatically rebalances your position to maintain the pool's price ratio, which can result in fewer tokens of the appreciating asset and more tokens of the depreciating one.
The term 'impermanent' suggests this loss can be reversed if prices return to their original ratio. However, in practice, this rarely happens, making the loss effectively permanent for most liquidity providers.
How Automated Market Makers Work
AMMs like Uniswap use a constant product formula: x × y = k. This means the product of the two token reserves must remain constant. When someone trades, the AMM automatically adjusts the price based on this formula.
As a liquidity provider, you own a percentage of the pool. When prices change, the AMM rebalances your position to maintain the constant product. This rebalancing is what causes impermanent loss.
A Simple Example
Let's say you provide liquidity to an ETH/USDC pool when ETH is $2,000. You deposit 1 ETH and 2,000 USDC (total value: $4,000). You now own 0.1% of the pool.
If ETH price doubles to $4,000, the AMM rebalances your position. You might end up with 0.707 ETH and 2,828 USDC (total value: $5,656).
If you had simply held 1 ETH and 2,000 USDC, you'd have $6,000. The difference ($344) is your impermanent loss. Use our crypto liquidity pool calculator to calculate impermanent loss for different scenarios.
Here's how impermanent loss scales with price changes:
| Price Change | Impermanent Loss | Example (ETH 2x) | Example (ETH 4x) |
|---|---|---|---|
| 1.25x | 0.6% | $4,000 → $5,000 | Minimal impact |
| 1.5x | 2.0% | $4,000 → $6,000 | Noticeable but manageable |
| 2x | 5.7% | $4,000 → $8,000 | Significant loss |
| 4x | 20.0% | $4,000 → $16,000 | Major loss |
| 10x | 44.5% | $4,000 → $40,000 | Devastating loss |
When Impermanent Loss Becomes Permanent
Impermanent loss becomes permanent when you withdraw from the pool at a different price ratio than when you entered. This happens in most cases because crypto prices rarely return to their exact original ratios.
The only way to avoid permanent loss is to withdraw when prices return to your entry ratio. This requires perfect timing and is nearly impossible to achieve consistently.
Factors That Increase Impermanent Loss
Volatility is the primary driver of impermanent loss. The more volatile the price ratio between your tokens, the higher your potential loss. This is why stablecoin pairs (like USDC/USDT) experience minimal impermanent loss.
Time also matters. The longer you stay in a pool with volatile assets, the higher the chance of significant price movements and resulting impermanent loss.
Correlation between assets matters too. If your tokens move in opposite directions, impermanent loss increases. If they move together, the impact is reduced.
Strategies to Minimize Impermanent Loss
Choose stable pairs. Pairs with low volatility, like stablecoin pairs or wrapped versions of the same asset, experience minimal impermanent loss.
Focus on high-yield pools. If the trading fees and rewards exceed your impermanent loss, you still come out ahead. This is why many successful liquidity providers focus on high-volume trading pairs.
Use single-sided liquidity provision. Some protocols allow you to provide liquidity with just one token, reducing impermanent loss risk.
Consider dynamic fees. Some AMMs adjust fees based on volatility, providing higher compensation during periods of high impermanent loss risk.
Calculating Your Potential Returns
Before providing liquidity, calculate your expected returns. You need to consider trading fees, rewards, and potential impermanent loss. Use our crypto yield farming calculator to estimate your net returns after accounting for impermanent loss.
Remember that high APY doesn't always mean high net returns. A pool with 100% APY but 50% impermanent loss might be worse than a pool with 20% APY and 5% impermanent loss.
Common Misconceptions
Many people think impermanent loss only affects the token that goes up in price. In reality, it affects both tokens in the pair. The AMM rebalances your position to maintain the constant product formula.
Another misconception is that impermanent loss is always bad. If the trading fees and rewards exceed the impermanent loss, you still profit overall. The key is understanding the trade-offs.
Some believe that providing liquidity to new tokens is always profitable due to high rewards. However, new tokens often have extreme volatility, leading to massive impermanent loss that can wipe out all rewards.
Real-World Examples
During the 2021 bull run, many liquidity providers in ETH/altcoin pairs experienced significant impermanent loss. While ETH appreciated, many altcoins appreciated even more, causing substantial rebalancing.
Conversely, during bear markets, liquidity providers in stablecoin pairs often outperform holders of volatile assets, as they avoid the price depreciation while still earning trading fees.
Advanced Strategies
Some advanced strategies include using options to hedge against impermanent loss, or providing liquidity in multiple pools to diversify risk. However, these strategies require significant expertise and capital.
Another approach is to focus on pools with high trading volume relative to liquidity. These pools generate more fees, which can offset impermanent loss more effectively.
Tax Implications
Impermanent loss has tax implications. When the AMM rebalances your position, it may trigger taxable events. Each rebalancing could be considered a sale and repurchase of tokens.
The complexity of tracking these events makes liquidity provision particularly challenging from a tax perspective. Consider using specialized tools or consulting with a crypto tax professional.
When to Avoid Liquidity Provision
Avoid providing liquidity if you believe one token will significantly outperform the other. In this case, holding the tokens directly would be more profitable.
Also avoid pools with low trading volume and high volatility. The fees won't compensate for the impermanent loss, and you'll likely lose money overall.
If you're not comfortable with the complexity of tracking impermanent loss and managing your position, consider simpler strategies like compound interest through staking instead.
The Bottom Line
Impermanent loss is an inherent risk of providing liquidity to AMMs. While it can't be completely avoided, understanding how it works helps you make informed decisions about which pools to join and how long to stay.
The key is to focus on pools where the trading fees and rewards exceed the expected impermanent loss. This often means choosing stable pairs, high-volume pools, or pools with additional incentives that compensate for the risk.
Remember that liquidity provision is not a passive investment. It requires active management, monitoring, and understanding of market dynamics. Only provide liquidity with funds you can afford to lose and with a clear understanding of the risks involved.
