Impermanent loss (IL) is the most misunderstood concept in DeFi liquidity providing. It’s the difference between holding tokens in a pool versus simply holding them in your wallet. Understanding IL is crucial for evaluating LP opportunities.
What is Impermanent Loss?
When you provide liquidity, your token ratio changes as trades occur. If prices move significantly, you may have been better off simply holding your original tokens.
How IL Happens
Example: You provide 1 ETH + 2,000 USDC when ETH = $2,000
If ETH price doubles to $4,000:
- Just holding: 1 ETH ($4,000) + 2,000 USDC = $6,000
- LP position: ~0.707 ETH ($2,828) + 2,828 USDC = $5,656
- Impermanent loss: $344 (5.7%)
IL by Price Change
| Price Change | Impermanent Loss |
|---|---|
| 1.25x (25% up) | 0.6% |
| 1.50x (50% up) | 2.0% |
| 2x (100% up) | 5.7% |
| 3x (200% up) | 13.4% |
| 5x (400% up) | 25.5% |
Why “Impermanent”?
The loss is “impermanent” because:
- If price returns to entry, IL disappears
- Only realized when you withdraw
- Fees earned may offset the loss
Mitigating IL
- Correlated pairs: ETH/WBTC moves together
- Stablecoin pairs: USDC/DAI has minimal IL
- High volume pools: Fees offset IL
- V3 ranges: Active management can help
Key Takeaways
- IL is the cost of rebalancing as prices change
- Greater price divergence = greater IL
- “Impermanent” because it reverses if price returns
- Fees earned must exceed IL for profit
- Choose pairs wisely to minimize IL risk