Impermanent Loss — Trading Wiki

What Impermanent Loss means

The opportunity cost of providing liquidity in a DEX pool compared to simply holding the assets. Occurs when token prices diverge from their ratio at deposit time.

In depth

Impermanent loss (IL) is a phenomenon unique to decentralized finance (DeFi) liquidity provision that represents the difference in value between holding two assets in a liquidity pool versus simply holding those same assets in a wallet. The 'loss' occurs when the relative prices of the paired tokens change from their ratio at the time of deposit — the greater the price divergence, the larger the impermanent loss. The term 'impermanent' refers to the fact that the loss is only realized when the liquidity provider withdraws their position. If the prices return to their original ratio before withdrawal, the loss disappears.

However, in practice, significant price divergence is common and persistent, making the loss very real for many liquidity providers. The mathematics of impermanent loss in a constant product AMM (like Uniswap v2) follow a precise formula: IL = 2 × √(price_ratio) / (1 + price_ratio) - 1, where price_ratio is the ratio of the new price to the original price. If one token doubles in price (2x), the IL is approximately 5.7%. If one token 5x's, the IL is approximately 25.5%. These percentages represent the amount by which the liquidity position underperforms a simple buy-and-hold strategy.

Liquidity providers accept impermanent loss risk in exchange for trading fee income. Every swap that occurs in the pool generates a fee (typically 0.3% on Uniswap v2) that is distributed proportionally to liquidity providers. The key question for any LP position is whether the accumulated trading fees exceed the impermanent loss over the holding period.

Key points

• Value difference between LP position and simply holding the tokens
• Increases as the price ratio of paired tokens diverges from deposit ratio
• Only 'realized' upon withdrawal — can reverse if prices converge

Practical tip

Provide liquidity only in stablecoin pairs (USDC/USDT) or highly correlated pairs (stETH/ETH) to minimize impermanent loss while still earning fees. For volatile pairs, only LP when you believe the assets will converge in price — and always calculate your break-even fee income first.

Why it matters when you are learning

Impermanent loss is the hidden cost of DeFi yield farming. Understanding it prevents you from being lured by high APY numbers that don't account for the IL you're absorbing.

Practising Impermanent Loss on the simulator

Reading about Impermanent Loss and using it are different skills. Try it once in the simulator on an instrument you already follow, write down beforehand what you expect to happen, and check the journal a day later to see whether it played out that way. Educational simulation only — not financial advice.