What Is Impermanent Loss? (A Complete Beginner’s Guide to DeFi Liquidity Pools)

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What Is Impermanent Loss? A Beginner’s Guide to DeFi Liquidity Pools

Category：Tools & Resources → Wallet & On-chain
Length：≈1500 words

What Is Impermanent Loss? (A Complete Beginner’s Guide to DeFi Liquidity Pools)

If you plan to provide liquidity on platforms like Uniswap, PancakeSwap, Curve, Balancer, SushiSwap, or other AMM-based DEXes, you will face a unique risk called Impermanent Loss (IL).

This concept is confusing for beginners, but it is essential to understand before depositing into liquidity pools. Impermanent loss can reduce your returns — even when the liquidity pool pays high APR or fee rewards.

This guide explains:

  • What impermanent loss is
  • Why it happens
  • How liquidity pools work
  • Real examples
  • When liquidity providing is profitable
  • How to avoid or reduce IL

Let’s break it down step by step.

1. What Is a Liquidity Pool?

On decentralized exchanges (DEXes), trading is powered by AMMs (Automated Market Makers) rather than traditional order books.

Liquidity pools contain two assets, usually in a 50/50 ratio by value, such as:

  • ETH / USDT
  • BNB / BUSD
  • SOL / USDC
  • UNI / ETH

Liquidity providers (LPs) deposit tokens into the pool so traders can swap instantly.

LPs earn:

  • Trading fees (e.g., 0.3% per swap)
  • Sometimes additional farming rewards

But they also face impermanent loss.

2. What Is Impermanent Loss? (Simple Explanation)

Impermanent loss occurs when the price of your deposited assets changes relative to each other.

When the price changes, the AMM automatically rebalances the pool:

  • If one token increases in price
    → The pool will reduce your holdings of that token
    → And increase your holdings of the token that performed worse

This happens because the AMM must maintain a constant ratio.

The loss is “impermanent” only if the price returns to its original level.
If you withdraw when the price has moved significantly, the loss becomes permanent.

3. Why Liquidity Pools Cause Impermanent Loss

AMMs follow a mathematical formula:

x × y = k
Where:

  • x = amount of Token A
  • y = amount of Token B
  • k = constant

When price changes, the AMM shifts the ratio of tokens you own.

This means:

  • When a token pumps → you get LESS of it
  • When a token dumps → you end up holding MORE of it

You ALWAYS end up holding more of the underperforming asset.

This is the cause of impermanent loss.

4. Real Example of Impermanent Loss

Let’s say you deposit:

  • 1 ETH (worth $1,000)
  • 1,000 USDT

Total value = $2,000

4.1 Price Doubles: ETH goes from $1,000 → $2,000

Your liquidity now gets rebalanced by the AMM.
Instead of holding 1 ETH and 1,000 USDT, you now hold:

  • 0.7 ETH
  • 1,414 USDT

Total value = $0.7 × 2,000 + 1,414 = $2,814

If you simply held your assets (without LPing), value would be:

  • 1 ETH = $2,000
  • 1,000 USDT = $1,000
    Total = $3,000

❌ Your impermanent loss:

3,000 – 2,814 = $186 loss (~6.2%)

Even though you earned trading fees, you lost potential gains from ETH pumping.

4.2 Price Drops: ETH goes from $1,000 → $500

AMM rebalances again.
You now hold:

  • 1.41 ETH
  • 707 USDT

Total value = 1.41 × 500 + 707 = $1,412

If you simply held:

  • 1 ETH = $500
  • 1,000 USDT
    Total = $1,500

❌ Your impermanent loss:

1,500 – 1,412 = $88 loss (~5.8%)

You end up holding more ETH — the token that dropped in value.

5. When Is Impermanent Loss Most Severe?

Impermanent loss increases when prices diverge significantly.

✔ Small price changes → small IL (1–5%)

✔ Large price changes → large IL (10–40%)

✔ Extreme volatility → very large IL (up to 50%+)

Pairs with volatile assets (e.g., ALT / USDT) carry the highest risk.

6. When Impermanent Loss Matters MOST

Impermanent loss is most dangerous when:

❌ Pool contains a highly volatile token

(e.g., meme coins, small caps)

❌ Token is trending strongly upward

LPs lose exposure to the upward performer.

❌ Trade volume is low

You don’t earn enough fees to offset IL.

❌ You provide liquidity at market tops

Price divergence increases.

7. When Liquidity Providing Can Still Be Profitable

Impermanent loss is not always bad — LPing can be profitable if:

✔ Trading volume is high

Fees can exceed IL

✔ APY rewards are strong

Many pools offer extra farming incentives

✔ Token prices remain stable

E.g., stablecoin pools (USDC/USDT, DAI/USDC)

✔ You LP in “blue chip” pairs

ETH/stables, BTC/stables, ETH/BTC

✔ You LP in wide-range concentrated liquidity (Uniswap V3)

Higher fee capture within a price range

LPing is profitable only when fee income + rewards > impermanent loss.

8. Best Pools for Avoiding Impermanent Loss

8.1 Stablecoin Pools (Low IL)

Examples:

  • USDC / USDT
  • DAI / USDC
  • TUSD / USDT

Price stays close → IL is minimal.

8.2 Blue Chip Pools (Moderate IL)

Examples:

  • ETH / USDT
  • BTC / USDC

Volatility is manageable and fees are decent.

8.3 Correlated Asset Pools

Examples:

  • ETH / stETH
  • BTC / WBTC

Prices move together → IL is very small.

8.4 Uniswap V3 Concentrated Liquidity

You earn much higher fees but must monitor price range.

9. How to Reduce Impermanent Loss (Practical Tips)

✔ Choose low-volatility pairs

Stablecoin pools or correlated assets.

✔ Use smaller liquidity ranges

On Uniswap V3 → higher efficiency, smaller IL.

✔ Avoid providing liquidity during extreme volatility

Wait for market stabilization.

✔ Check trading volume

High volume = more fees = IL more likely offset.

✔ LP only a small portion of your portfolio

Do not risk everything.

✔ Use IL protection programs

Some platforms (like Bancor historically) offer IL insurance.

10. Should Beginners Provide Liquidity?

LPing requires understanding risk, so beginners should:

✔ Start with stablecoin pools

Very low IL risk.

✔ Avoid meme coins or new tokens

Huge IL risk.

✔ Start with small amounts

Learn how AMMs rebalance positions.

✔ Track your IL

Use tools like:

  • APY.Vision
  • DeFiLlama
  • GeckoTerminal
  • Zapper

11. Final Takeaway

Impermanent loss is one of the biggest risks in DeFi liquidity pools.

To summarize:

✔ IL happens when token prices diverge

✔ IL is unavoidable in volatile markets

✔ Stablecoin pools have low IL

✔ LPing can be profitable if fees > IL

✔ Always evaluate risk before depositing liquidity

Understanding impermanent loss helps you avoid common DeFi mistakes and protect your capital while exploring liquidity pools.