What is Impermanent Loss? Understanding the Hidden Risk in DeFi Pools

DeFi lets you earn fees by putting your tokens into a liquidity pool. This looks simple and safe at first. You add two tokens, and traders pay fees to use the pool. Over time, you get your share of those fees.

But there is a quiet risk that many people miss on day one. It is called impermanent loss. The word sounds complex, but the idea is simple: your tokens can end up worth less than if you had just held them in your wallet. This can happen even when the pool works as designed and even when no one steals funds.

This guide explains what is impermanent loss, when it happens, how to measure it in simple steps, and how to lower the risk. We will use plain words, small math, two clear tables, and real-world style examples. By the end, you will know how to judge a pool, and you will know how to weigh fees and rewards against the risk of loss.

What Is Impermanent Loss?

Impermanent loss is the gap between two outcomes:

• Outcome A: You add two tokens to an AMM pool (like a 50/50 ETH/USDC pool).
• Outcome B: You do nothing and just hold those same tokens in your wallet.

After prices move, the value of your pool share can be less than the value of simply holding the tokens. That gap is the impermanent loss. It is “impermanent” because, in theory, if prices return to the exact starting ratio, the gap goes away. But in real markets, price moves can last. If you withdraw while the price ratio is different from the start, the loss becomes real.

Why does this happen? AMM pools follow a rule to keep a balance between the two tokens. When one token becomes more valuable, the pool holds less of that token and more of the cheaper token. The pool keeps trading against arbitrage traders until the pool price matches the market price. This “rebalancing” means that your final mix of tokens can be worse than the mix you started with, compared with just holding.

Key points:

• Impermanent loss is not a bug. It is built into how AMMs work.
• It can happen even when fees are high and trading is heavy.
• Fees can offset impermanent loss, but they do not always cover it.
• Larger price changes create larger impermanent loss.

How Impermanent Loss Happens (Step by Step)

Let’s walk through a clean, simple case with a 50/50 pool.

1. Start: You add 1 ETH and 1,500 USDC to a pool. Let’s say ETH = 1,500 USDC. Your total value is 3,000 USDC. The pool is balanced: 50% ETH and 50% USDC.
2. Price moves: The market price of ETH rises to 3,000 USDC. In the open market, your original tokens (1 ETH + 1,500 USDC) would now be worth 4,500 USDC if you had just held them (1 ETH × 3,000 + 1,500 USDC).
3. Pool rebalances: The AMM must keep the product or balance rule (based on the pool type; a common one is the constant product rule). Arbitrage traders will buy the underpriced side and sell the overpriced side until the pool price matches the market. The pool ends up with less ETH and more USDC than before.
4. Your share changes: You still own the same percentage of the pool, but the pool now holds a different mix. Because the price of ETH went up, you now have fewer ETH and more USDC than if you had simply held 1 ETH and 1,500 USDC. When you withdraw, the total value of your share is less than the “just hold” case.
5. The gap is impermanent loss: That difference is the impermanent loss. If ETH later falls back to 1,500 USDC, the gap would, in theory, go to zero. But if you exit at the new price ratio, the loss is realized.

Important notes: 

• Impermanent loss can be small for small price changes.
• It grows as the price moves further away from the starting ratio.
• The direction does not matter. A big move up or down can create a loss in a 50/50 pool.

Also Read: Top 12 Decentralized Exchanges (DEXs) to Know in 2025

The Math in Simple Form

You do not need deep math to understand impermanent loss. Think of it as a simple comparison:

• Path A: You hold your two tokens in your wallet.
• Path B: You add the same tokens to a 50/50 AMM pool and later take them out.

After price moves, compare the total value from Path A and Path B. If Path B is worth less, the gap is impermanent loss.

Price Change vs. Impermanent Loss in a 50/50 Pool

In a 50/50 pool, bigger price moves create bigger losses. Here are helpful benchmarks:

These numbers are the shortfall vs. just holding. They are the same for an equal move up or down (for example, +50% and −33% are paired moves around the starting point and both lead to about 2.0% loss).

A Worked Example (Numbers You Can Follow)

• Start: You add $1,000 worth of Token A and $1,000 worth of Token B to a 50/50 pool. Total: $2,000.
• Price move: Token A doubles in price in the market.
• If you had just held, your $1,000 of Token A would now be $2,000, and you still have $1,000 of Token B → $3,000 total.
• In the pool, the AMM rebalances. You now hold fewer Token A and more Token B.
• Due to the AMM curve, your pool share value ends up at about $2,829.
• The gap vs. $3,000 is about $171, or 5.7% of $3,000. That is the impermanent loss.

This example shows why fees matter. If the pool paid you more than $171 in fees while the price moved, you could still come out ahead. If not, you underperformed the “just hold” case.

What Drives Impermanent Loss (And What Can Reduce It)

Now that you know what is impermanent loss and how it forms, let’s look at the drivers.

Size of Price Move

This is the main factor. Small moves → small IL. Large moves → large IL. Direction does not matter in a 50/50 pool. Extreme moves (like 10×) can create very large IL.

Pool Weight (50/50 vs. Other Mixes)

Not all pools are 50/50. Some are 80/20, 95/5, or other weights. The closer the weight is to 100/0 (i.e., you are almost just holding one asset), the lower the impermanent loss for a given price move on that asset. But there is a trade-off: fee income may be smaller because there is less of the volatile asset to trade.

Token Pair Type

• Stable–stable pairs (like USDC/DAI) usually have very small price moves around $1, so IL is typically small.
• Correlated pairs (like ETH/wstETH) tend to move together, which reduces IL compared with unrelated pairs.
• Volatile or uncorrelated pairs (like ETH/ALT) see larger moves, which increases IL.

Fees and Volume

Trading fees can offset IL. High volume can help you earn more fees. If the fee revenue during your time in the pool is greater than the IL, you may still net a profit. But fee income can change over time, and many pools slow down during quiet markets.

Liquidity Mining and Rewards

Some pools pay extra tokens as rewards. These can help cover IL. But reward tokens can drop in price. Rewards that look strong today may not hold value later.

Time in the Pool

The longer you stay in a volatile pair, the more chances there are for the price to drift far from the start, which can make IL larger. Holding for a short time around a stable period can reduce IL risk, but timing is hard.

Rebalancing Behavior

AMMs rebalance by design. This is what enables easy trading without an order book. But that same rebalancing creates the path for IL. You cannot “turn it off” in a standard AMM.

How to Lower Impermanent Loss (Practical Strategies)

There is no magic way to remove IL from an AMM that uses market-based pricing. But there are ways to reduce it or to offset it with fees and rewards. Here are the main approaches, in simple words.

Strategy 1: Choose Pairs With Lower Price Drift

• Stable–stable pairs often have tiny IL because both tokens aim to stay near $1.
• Correlated pairs (e.g., ETH/liquid staked ETH) also help, since they move together most of the time.

Strategy 2: Use Pools With Uneven Weights

• An 80/20 or 95/5 pool keeps most of your value in one token.
• This reduces IL vs. a 50/50 pool for the same price move.
• You still earn some fees, but you take less exposure to the second token.

Strategy 3: Consider Fee Levels and Expected Volume

• Higher fee rates can help cover IL, but high fees can also reduce trader demand.
• Look at historical volume and liquidity depth. If volume is steady and deep, fees can add up.
• Remember: past volume does not guarantee future volume.

Strategy 4: Look for Boosted Rewards (But Be Careful)

• Extra rewards can cover IL and more.
• Check vesting rules, reward tokens, and unlock schedules.
• If reward token prices fall, the boost may not be enough.

Strategy 5: Narrow Price Ranges (For Concentrated Liquidity AMMs)

• In some AMMs, you can set a price range for your liquidity.
• A narrow range can earn more fees per dollar when the price stays in the range.
• But if the price moves out of your range, you may end up holding only one token and stop earning fees, and your IL can lock in if you exit then.
• Use ranges that match your view and your risk level.

Strategy 6: Rebalance on Your Own Schedule

• You can withdraw when the price ratio is near your start point to reduce IL.
• This needs attention and timing. It may not suit everyone.

Strategy 7: Use Hedging (Advanced)

• Some users hedge with perps or options to manage the price risk of the pool.
• This can work, but it adds cost and complexity. Keep it simple if you are new.

Strategy 8: Size Your Position

• Only add what you can accept to underperform vs. holding.
• Use a small size first. Learn the pool’s behavior. Then decide if you want to add more.

Ways to Reduce IL: What They Do and Trade-offs

Also Read: How APR Works in Crypto: A Beginner’s Guide

When Impermanent Loss Can Be “Okay”

There are times when IL is acceptable:

• You expect strong fees that more than cover IL in your planned time frame.
• You want extra exposure to one token and you use an 80/20 pool to earn fees while holding it.
• You earn strong rewards and you plan to sell them steadily to lock gains.
• You are learning with a small size and see the pool as a low-cost lesson.

The key is to be clear about your goals. Do not add liquidity just because the APR looks high on a dashboard. Look under the hood and ask, “What is an impermanent loss for this pair, and can I cover it with fees or rewards?”

Conclusion

You now know what is impermanent loss. It is the shortfall that can appear when you add liquidity to an AMM and price moves away from your starting point. The pool’s rebalancing changes your mix of tokens, and that can leave you behind the “just hold” case.

The size of the loss depends on how far price moves, the pool weight, the pair type, and the time you stay in the pool. Fees and rewards can reduce or even cover the loss, but they are not a guarantee. Good planning means you check the likely price range, estimate IL with simple math, and decide on size and exit rules before you click “deposit.”

DeFi is powerful. It gives you tools that were once only for pros. But power needs care. Keep your words simple, your math honest, and your plan clear. Start small, learn, and grow only when you are ready. With this approach, you can use pools with calm eyes, and you can make better choices about when to seek fees and when to simply hold.