What Is Impermanent Loss? Simple Guide for DeFi Liquidity Providers

DeFi, or decentralized finance, gives anyone with a wallet a way to earn on crypto. One common way is to become a liquidity provider and earn trading fees from users who swap tokens. At first, this can look like “free money,” since the pool seems to earn fees all the time.

But there is a hidden risk that many new users do not see at the start. That risk is called impermanent loss. It can make a liquidity provider end up with less value than if the same tokens were simply held in a wallet and never put into a pool.

This article explains what impermanent loss is, why it happens, and how to think about it before using any DeFi protocol. The goal is to keep the language simple, show clear examples, and help readers ask better questions before they lock any money in a liquidity pool.

What Is Impermanent Loss?

Impermanent loss is the loss in value that a liquidity provider may see when the price of tokens inside a pool changes compared to when they were first deposited.

When someone adds tokens to a DeFi liquidity pool, the pool usually holds two tokens in a pair, such as ETH and USDC. The pool follows a fixed rule to keep a balance between the two tokens. When prices change, the pool automatically rebalances, and the provider’s share of the pool changes in amount and value.

Impermanent loss appears when the price of one or both tokens moves away from the original price. If the provider later withdraws from the pool, the value of the tokens received may be less than the value they would have had by simply holding them outside the pool.

It is called “impermanent” because, in theory, if prices move back to the original level, the loss can disappear. At that point, the liquidity provider may no longer have a loss compared to holding. But once the provider withdraws the tokens, the loss becomes permanent, because the position is closed and the outcome is locked in.

So, when asking “what is impermanent loss,” it is useful to remember this key idea:

Impermanent loss is not about your balance going down. It is about your balance going up less than it could have if you had just held the tokens.

How Liquidity Pools and AMMs Work

To understand what impermanent loss is, it helps to see how a liquidity pool works behind the scenes.

Most DeFi exchanges use something called an Automated Market Maker (AMM). Instead of matching buyers and sellers directly, an AMM uses a pool of tokens and a formula to set the price. A very common formula is:

x * y = k

Here:

• x is the amount of token A in the pool
• y is the amount of token B in the pool
• k is a constant number that does not change

When a trader swaps token A for token B, the pool receives some of token A and sends out some of token B. The formula must still hold, so the price that the trader gets is based on how the new amounts of tokens keep x * y equal to the same k.

Liquidity Provider Role

A liquidity provider (LP) puts both tokens into the pool, often in equal value, for example, 50 percent ETH and 50 percent USDC. In return, the LP gets LP tokens that show what share of the pool they own.

As traders use the pool, they pay a small fee that is added to the pool. The LP earns part of these fees. This is the reward for taking the risk of providing liquidity.

Where Impermanent Loss Fits In

Impermanent loss happens because the pool is always rebalancing. The LP ends up holding a different mix of tokens than at the start. If the price of one token moves a lot, the LP may finish with more of the token that went down in price and less of the token that went up in price. When compared to the simple “buy and hold” choice, this can be worse.

So, the DeFi model gives something and takes something:

• The LP earns fees
• The LP takes price risk, which appears as impermanent loss

Understanding this tradeoff is key for any DeFi user.

Also Read: Market Maker in Crypto: Core Strategies, Hedging Tactics, and Inventory Control Explained

Why Impermanent Loss Happens: Example and Table

This section will walk through a very simple example of what impermanent loss is. The numbers are not perfect, but they show the idea.

Simple example

Imagine a pool with these details:

• Pair: ETH / USDC
• Starting ETH price: 1 ETH = 1,000 USDC
• A new LP deposit: 1 ETH and 1,000 USDC
• Total value at deposit: 2,000 USD

Let us also assume the pool is only this one deposit, to keep things simple.

Now, suppose the market price of ETH rises from 1,000 USDC to 2,000 USDC. Traders will use this pool to buy ETH until the pool price matches the new market price. As they buy ETH from the pool, they put USDC into the pool. The pool ends up with:

• Less ETH
• More USDC

The LP still owns 100 percent of the pool, but the mix has changed. If the LP withdraws after the price change, they might end up with something like:

• 0.71 ETH and 1,414 USDC (numbers rounded only to show the idea)

Now check the values:

• 0.71 ETH at 2,000 USDC each = 1,420 USDC
• Plus 1,414 USDC
• Total ≈ 2,834 USDC

If the LP had just held the original tokens, without providing liquidity:

• 1 ETH at 2,000 USDC = 2,000 USDC
• Plus 1,000 USDC
• Total = 3,000 USDC

So, by being in the pool, the LP has ~2,834 instead of 3,000. The difference of 166 USDC is the impermanent loss. The LP still made money in absolute terms (2,834 is higher than the 2,000 at the start), but they made less than the simple hold strategy.

Holding vs Liquidity Providing in the Example

Here is a simple table that compares the two choices.

Table 1: Example of Impermanent Loss after ETH price rises

In this example, what is impermanent loss?

It is the difference between the “just hold” value and the “withdraw from pool” value:

• 3,000 − 2,834 = 166 USDC (approximate impermanent loss)

If trading fees earned by the LP are higher than this 166 USDC, then the LP could still be better off as an LP than by just holding. This is why many LPs stay in pools with high trading volume and good fee income.

How Impermanent Loss Changes with Price Moves

The size of impermanent loss depends on how much the price changes from the original level. Small price changes create small impermanent loss. Large price changes create larger impermanent loss.

In simple terms:

• If the price of one token in the pair doubles or falls by half, the impermanent loss can already be quite clear.
• If the price moves by 5 or 10 percent, the impermanent loss is much smaller and may be covered by trading fees.

The relationship is not linear. A 2x move is worse than two 1.5x moves in many setups. The exact math depends on the AMM formula, the fee rate, and other rules, but the intuition is clear: bigger price swings mean bigger impermanent loss.

Price Change vs Impermanent Loss (50/50 pool, rough idea)

This table gives a rough idea of how much impermanent loss appears for a simple 50/50 pool when the price of one token moves and the other stays stable. Values are rounded and used for education, not exact calculation.

Table 2: Approximate impermanent loss vs price change

This table shows two key points:

1. Small moves create very small impermanent loss. In a liquid market with many trades, fees can often cover that.
2. Large price swings create much larger impermanent loss. If the price of one token triples, the LP can lag far behind the simple “hold” strategy.

When reading this, it is good to remember that many crypto assets have strong price swings. Some DeFi pairs are much more stable than others. This is one reason why many LPs like stablecoin pairs (such as USDC/USDT), where both tokens try to hold a fixed peg, so price changes are usually small.

How To Reduce Impermanent Loss Risk

No strategy can remove risk fully, but there are several ways to reduce the chance or size of impermanent loss. This article will list some common ideas that DeFi users often explore.

Use Pairs with Lower Volatility

The simplest method is to choose token pairs where prices do not move a lot against each other, for example:

• Stablecoin/stablecoin (USDC / USDT, DAI / USDC)
• Tokens that follow the same index or asset
• “Liquid staking token” and its base asset (for example, staked ETH token and normal ETH), if they stay close in price

If both tokens move together, price divergence is smaller, and impermanent loss is lower.

Prefer Pools with Strong Fee Income

Trading fees are the main way to offset impermanent loss. When a pool has:

• High trading volume
• Reasonable fee rates
• Many swaps per day

The LP gains more from fees. If total fees are greater than the impermanent loss created by price moves, the LP can still end up ahead of the hold strategy.

This article suggests checking:

• The pool’s past trading volume
• The fee rate (for example, 0.3 percent per swap)
• How long the position is likely to stay open

Use “Concentrated Liquidity” with Care

Some newer AMMs let LPs provide liquidity only in a narrow price range. This is called concentrated liquidity. It can:

• Increase fee income, because the same capital supports more trades in that range
• Increase price risk, because if the price moves outside the chosen range, the position may stop earning fees and may shift to one asset

For beginners, this kind of product can be complex. Concentrated liquidity gives more control, but also more choices to get wrong. It is important to understand what range means, how it works, and what happens if the price breaks out of the range.

Start Small and Learn

Even if someone understands the theory of what impermanent loss is, the real feeling of seeing a position move can be different. Because of this, many users choose to:

• Start with a small test position
• Track how its value changes over days or weeks
• Compare it with the simple holding of the same tokens
• Adjust or exit if they do not like the risk

This is not just about numbers but also about personal comfort with volatility and open positions.

Consider Time Frame

Impermanent loss is not only about how far the price moves, but also when the LP enters and exits the pool. For example:

• If a token’s price spikes and then returns to the old level, the loss may look large in the middle but small in the end.
• If the LP enters right before a strong price move, the loss can be heavier than if they had entered long before.

Since no one knows the future price path for sure, this risk is always present. Time in the pool matters.

Also Read: What Is Wrapped Bitcoin? Benefits, Risks, and When to Use It in DeFi

Should You Provide Liquidity? Key Questions To Ask

Impermanent loss does not mean that providing liquidity is always a bad idea. It means that the LP should weigh the fee rewards against price risk and compare it with simply holding.

This article suggests a few simple questions that any user can ask before adding tokens to a pool:

What is impermanent loss in this specific pool?

• How much could be lost if prices change by 20 percent, 50 percent, or 100 percent?
• Are there tools or calculators that show this?

What is the realistic fee income?

• How much in fees did the pool earn in the past week or month?
• Is trading volume stable, rising, or falling?

What is the risk level of the tokens themselves?

• Are the tokens very volatile or more stable?
• Is one token a stablecoin and the other a risky asset?

What is the smart contract risk?

• Even if the price and fees look good, there is also the risk of bugs or hacks in the protocol.

What time frame is in mind?

• Is the goal to provide liquidity for days, weeks, or months?
• How often will the position be checked?

By thinking through these questions, a person can better see if the possible fees are worth the possible impermanent loss and other risks.

Conclusion

Impermanent loss is a core concept in DeFi that every liquidity provider should understand. It is not only about the balance moving up or down. It is about how the value of a liquidity position compares to simply holding the same tokens outside the pool.

This article showed that impermanent loss happens when token prices move away from the original deposit price. The pool’s AMM formula forces a new balance between tokens, so the LP ends up with a different mix of assets. In strong price moves, this new mix can be worth less than the “just hold” strategy, even when the LP still earns fees.

DeFi can be powerful, but it is not risk-free. Before adding tokens to any pool, it is wise to ask what impermanent loss is for that pool, how big it could be, and whether trading fees can realistically make up for it. Users, especially those who are new or young, should avoid rushing, start small, and discuss important money choices with trusted adults or professionals. With clear thinking and patience, it is possible to use DeFi tools more safely and understand both the rewards and the risks that come with them.