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Learn what impermanent loss is, why it happens when providing liquidity in DeFi, how to calculate it, and when it does and doesn't matter in 2026.
What is Impermanent Loss? The Hidden Cost of Providing Liquidity
Impermanent loss is the difference in value between holding tokens directly versus depositing them into a liquidity pool. When prices of the tokens in a pool diverge from their ratio at the time of deposit, liquidity providers end up with a different token balance than they started with, and that balance is typically worth less than simply holding the original tokens.
The term 'impermanent' reflects that the loss only crystallizes if you withdraw while prices are diverged from your entry ratio. If prices return to exactly where they were when you deposited, the impermanent loss disappears. However, in practice, prices rarely return to their exact original ratio, making impermanent loss a real and permanent cost for many liquidity providers.
It is one of the most important concepts to understand before providing liquidity in any DeFi protocol.
Why Impermanent Loss Happens: AMM Mechanics
Impermanent loss is a direct consequence of how AMM pools rebalance themselves.
When you deposit equal values of ETH and USDC into a pool, you receive LP tokens reflecting your share. As ETH's price rises, arbitrageurs buy ETH from the pool because it is cheaper there than on external markets. This process continues until the pool price matches the external price, at which point the pool holds less ETH and more USDC than at the start.
When you withdraw, you receive the current ratio: less ETH and more USDC than you deposited. The ETH you are missing out on represents the impermanent loss. You sold your ETH upside to the arbitrageurs who kept the pool price in sync with the market.
The same logic applies in reverse when prices fall: the pool accumulates more of the falling asset, giving you more exposure to the downside than simply holding would have.
Calculating Impermanent Loss: How Bad Can It Get?
Impermanent loss scales with price divergence. The relationship is nonlinear.
If one token in a pair doubles in price relative to the other, you experience roughly 5.7 percent impermanent loss compared to holding. If it triples, the loss is about 13.4 percent. If it increases tenfold, impermanent loss reaches about 42 percent. If it goes to near-zero, the loss approaches 100 percent since the pool accumulates the collapsing asset.
This calculation assumes the standard 50/50 constant product AMM. Some protocols offer different weightings, such as 80/20 pools on Balancer, which reduce impermanent loss for volatile assets while maintaining liquidity.
Impermanent loss calculators are freely available online and worth using before entering any LP position with volatile assets. Enter your expected price scenarios and see the impermanent loss outcome before committing capital.
When Impermanent Loss Matters and When It Doesn't
Whether impermanent loss is a problem depends entirely on what you are comparing it to and what fees you earn.
For stable pairs like USDC and USDT, or correlated assets like ETH and stETH, price divergence is minimal. Impermanent loss is negligible, and fee revenue is the primary driver of returns. These pools are popular among conservative LPs seeking predictable yields.
For volatile pairs, the calculus is more complex. If you earn enough trading fees to more than compensate for impermanent loss, the position is profitable compared to holding. During periods of high trading activity, fee revenue can be substantial and may offset significant impermanent loss. But during low-activity periods with continued price divergence, impermanent loss can quietly exceed fee income.
The critical insight: if you are bullish on an asset and plan to hold it regardless, providing liquidity in a volatile pair gives you the same upside exposure with a fee income overlay, but caps some of the upside in fast-moving markets.
Strategies to Mitigate Impermanent Loss
Several approaches reduce impermanent loss exposure while still allowing liquidity provision.
Correlated asset pairs reduce price divergence risk substantially. Providing liquidity for ETH and a liquid staking derivative like stETH or cbETH means both assets move together, keeping the pool ratio stable while still generating fees.
Concentrated liquidity positions can be structured around a narrow range where you expect the price to stay, maximizing fee income without exposure to the extreme divergence scenarios where impermanent loss is highest. This requires active management.
Some protocols offer impermanent loss protection as a feature, either through insurance mechanisms or token incentive top-ups that compensate providers if impermanent loss exceeds a threshold. These protections vary in reliability and sustainability.
Hedging the delta exposure of an LP position using options or perpetual futures is an advanced strategy used by professional market makers to neutralize price risk while retaining fee income.
Impermanent Loss: Understand It Before You Earn From It
Impermanent loss does not make liquidity provision a bad strategy. It makes it a strategy with a specific risk profile that requires understanding before participating.
For stable pairs and correlated assets, impermanent loss is minimal and LPs can earn attractive yields with limited downside. For volatile pairs, impermanent loss can be significant, and the decision to provide liquidity should be made with a clear view of the fee income needed to compensate.
The name 'impermanent' can lull providers into underestimating the risk. Approach every LP position with a concrete understanding of the impermanent loss scenario if prices move significantly, and make sure the potential fee income justifies that exposure.
This information, including any opinions and analyses, is for educational purposes only and does not constitute financial advice or recommendation. You should always conduct your own research before making any investment decisions and are solely responsible for your actions and investment decisions.
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