What Is Impermanent Loss? Definition & Example

Impermanent loss is the gap between what a liquidity provider ends up with and what they would have had by simply holding the two assets. It arises because an automated market maker continuously rebalances the pool as prices move, mechanically selling the appreciating asset and buying the depreciating one.

The name is misleading and has cost people money. The loss is "impermanent" only in the sense that it reverses if prices return to their original ratio. If they do not — and for volatile assets they usually do not — you realise it on withdrawal. It is a perfectly permanent loss with an optimistic name.

The magnitude depends only on how far the price ratio diverges, and it is unforgiving at the extremes. A 1.25x divergence costs about 0.6%. A 2x divergence costs 5.7%. A 4x divergence costs 20%. A 5x divergence costs 25.5%. Those percentages are measured against simply holding, and they apply regardless of which direction the divergence went.

Liquidity providers are compensated through trading fees and often through additional token incentives. The position is profitable when those exceed impermanent loss — which is why stablecoin pairs, where divergence is minimal by construction, are attractive despite modest fee income, and why volatile pairs need substantial fee volume to be worth providing to.

Before providing liquidity, estimate the divergence you expect over your holding period and compare it against the advertised yield. A 40% APY on a pair where one asset plausibly triples is not the trade it appears to be. Concentrated liquidity designs amplify both the fees and the loss.