Impermanent Loss

Impermanent loss is the reduction in value that liquidity providers experience compared to simply holding their tokens, caused by the price of one token in a pool changing relative to the other. It is called “impermanent” because the loss only becomes real if you withdraw your liquidity while the price is still diverged from when you deposited. If the prices return to their original ratio, the impermanent loss disappears.

Here is why it happens. When you deposit two tokens into an AMM pool, the pool is continuously rebalancing them as trades occur. If one token doubles in price, the AMM automatically sells some of it as buyers come in and adjusts the pool composition, leaving you with less of the appreciated token and more of the token that did not go up. A person who just held those same tokens outside the pool would have more of the valuable token. The difference between what you actually have in the pool and what you would have had by holding is the impermanent loss.

The counterweight to impermanent loss is trading fees. If the pool is heavily traded, fee income can more than compensate for the loss. Stablecoin pairs (where both tokens are designed to hold a fixed value) suffer virtually no impermanent loss because the ratio between them rarely changes. For volatile assets, impermanent loss can be significant, and understanding it is essential before committing funds to a liquidity pool.

Example: You deposit $500 worth of Ether and $500 worth of USDC into a pool (total $1,000). Ether then doubles in price. If you had just held both tokens, you would have $1,500. When you withdraw from the pool, you get back roughly $1,414 because the AMM has been selling your Ether to buyers as it rose. You still made money compared to your initial deposit, but you made less than if you had simply held. That $86 gap is the impermanent loss.