What Is Impermanent Loss and How to Avoid It

What impermanent loss actually is

If you've read our DeFi guide, you already know that a liquidity pool is a pot of two tokens that an automated market maker (AMM) uses to let people swap between them. Deposit into that pool and you become a liquidity provider (LP), earning a share of the trading fees every time someone swaps against it.

Impermanent loss is the gap between what your deposit is worth if you withdraw it today versus what those same tokens would be worth if you'd just held them in a wallet instead of depositing them. It shows up whenever the price of one token in the pool moves relative to the other. It isn't a fee, a hack, or something going wrong. It's a direct, mechanical side effect of how AMMs work, and it happens to some degree almost every time two token prices drift apart. For a quick refresher on AMM and liquidity pool terminology, our glossary has plain definitions.

A concrete example

Say you deposit into a pool holding Token A and Token B, both trading at $10. You put in 50 of each, so your deposit is worth $1,000 total ($500 of A, $500 of B). Most AMMs price trades using a constant-product formula, meaning the amount of A in the pool multiplied by the amount of B always equals the same number (called k). Here, k is 50 x 50, or 2,500.

Now imagine Token A doubles to $20 while Token B falls by half to $5. Traders will buy the now-underpriced Token B from the pool and sell in the now-overpriced Token A, arbitraging the pool's price until it matches the market. When that settles, the pool still has to satisfy x times y equals 2,500, but now at a ratio that reflects the new prices. The math works out to 25 A and 100 B in the pool.

Notice what happened: you now hold less of Token A, the one that rose, and more of Token B, the one that fell. That's the AMM automatically rebalancing you out of the winner and into the loser as the price moves. If you withdrew right now, you'd get 25 A ($500) and 100 B ($500), for $1,000 total. But if you'd simply held your original 50 A and 50 B in a wallet, you'd have 50 x $20 plus 50 x $5, which is $1,250. That $250 difference, 20% less than just holding, is your impermanent loss.

Why it's called "impermanent"

The loss only becomes real, or "permanent," the moment you withdraw your liquidity while prices are still diverged. Up until then it's just a paper gap between two hypothetical outcomes. If Token A and Token B's prices later drift back toward where they were when you deposited (both back near $10), the pool rebalances back toward your original 50/50 mix and the loss shrinks or disappears entirely, even though you never touched your position.

That's the whole reason the term exists: the loss is only locked in by the act of withdrawing, not by the price movement itself. It's a real risk, but it's not guaranteed to cost you anything if you're able to wait out the divergence.

What makes it worse, and what makes it milder

Impermanent loss gets bigger the more the two token prices move apart from each other, in either direction. A pool where both assets barely move relative to one another will have almost none. A pool where one asset moons while the other craters will have a lot, as the example above shows.

That's why the two tokens you pick matter so much. Stablecoin-to-stablecoin pools (like two dollar-pegged tokens that are each supposed to trade near $1) see very little divergence, so impermanent loss is minimal. The same goes for pairing an asset with something that closely tracks its price, like ETH paired with a liquid staking token built to mirror ETH's value; see our guide to liquid staking and restaking for how that pairing works. Pool two unrelated, volatile assets that have no reason to move together, on the other hand, and you're exposed to much bigger swings and much bigger potential impermanent loss.

How you get paid for taking this risk

Providing liquidity isn't a one-way bet against yourself. Every swap that happens against your pool pays a small fee, and that fee gets split among the LPs in proportion to how much liquidity they've supplied. Some pools also hand out extra token rewards on top of fees to attract liquidity, which is what people mean when they talk about yield farming.

The real question for any LP position isn't "is there impermanent loss risk," because there almost always is some. It's whether the fees and any extra incentives you collect over the time you're providing liquidity add up to more than the impermanent loss you're exposed to. A high-fee, high-volume pool with a correlated pair can be a genuinely good deal. A low-fee pool pairing two volatile, unrelated tokens can lose money even with a decent-looking advertised yield.

Practical guidance

If you're new to providing liquidity, start with pools where impermanent loss risk is lowest: stablecoin pairs or correlated-asset pairs like ETH and a liquid staking token. Those won't diverge much, so your main variable becomes the fee income, which is easier to reason about.

If you're considering a volatile-volatile pool because the advertised annual percentage yield (APY) looks big, treat that number as a starting point, not a promise. Think through how far the two tokens could realistically drift apart over your holding period, and whether the fees you'd realistically collect would cover that gap. "Yield farming APY" is not risk-free income sitting on the table. It's compensation for a real risk, and it's worth understanding that risk rather than assuming the number on the screen is what you'll actually walk away with.