Impermanent Loss Explained: What Providing Liquidity Really Costs

The formula, and why the loss is symmetric

A constant-product pool keeps the product of its two reserves fixed, which forces it to sell whichever token is rising and buy whichever is falling. That is the entire mechanism: the pool rebalances against you, automatically and continuously. Because the rebalancing depends only on how far the price ratio has moved, the loss depends only on r — the price of token A divided by the price of token B, expressed relative to where the ratio stood on the day you deposited. IL = 2 × √r ÷ (1 + r) − 1 comes straight out of that constraint, with no assumption about volatility, trading volume or time.

The symmetry surprises people. Feed r = 2 into the formula and you get −5.72 percent; feed r = 0.5 and you get −5.72 percent again. A token that doubles and a token that halves cost the liquidity provider exactly the same, because 2 and 0.5 are the same distance from parity in ratio terms. That is also why the loss grows so slowly at first and then bites: a 25 percent move costs 0.62 percent, a 50 percent move 2.02 percent, a doubling 5.72 percent, a five-fold move 25.46 percent. Small drifts are almost free; a token that runs away from its pair is where the money goes.

Nothing about it is impermanent

The name is the most misleading word in decentralised finance. It survives because the loss does unwind if the price ratio returns exactly to where it stood when you deposited — and that is true. But it is a conditional promise about the future, not a description of your position. The moment you withdraw, the pool hands you whatever token amounts the current ratio implies, and the gap against holding is realised in full. Nothing about it is more temporary than any other loss you choose to take.

It is also not a fee. Nobody deducts it, no line item shows it, and the pool interface will happily report a position that has grown in dollar terms while it has fallen behind holding. In the worked example the position went from $10,000 to $14,142 — a 41 percent gain that a dashboard will display in green — and still cost $858 against doing nothing. Impermanent loss is an opportunity cost you only see if you compute the counterfactual yourself, which is exactly why so many providers never notice it.

Fees are the only reason the position can pay

Liquidity provision is a trade: you accept the rebalancing loss in exchange for a share of the swap fees. So the only question that matters is whether the fees beat the gap. At a 20 percent annualised fee return — a healthy figure for a major pair — it takes about 104 days of fee income to cover the 5.72 percent gap that a doubling creates, and about 209 days at 10 percent. If the pair moves that far in a fortnight, the fees never had time.

The trap is that the two sides move together. Volatility is what generates swap volume, and volatility is what pushes r away from 1 — so the pools advertising the highest fee returns are usually the ones where the ratio is moving fastest. Concentrated liquidity sharpens both edges: inside your range you earn far more fees per unit of capital, and outside it you hold 100 percent of the losing token with the loss no longer capped by the gentle curve. Run the numbers on the pair you are actually considering, over the period you actually intend to stay in, before you accept the headline yield as the return.

Frequently asked questions

Is impermanent loss deducted from my position?

No. It is not a charge and it does not appear on any statement. Your position can be worth more than you deposited and still carry a large impermanent loss, because the comparison is against holding the same two tokens untouched, not against your entry value. The only way to see it is to compute both numbers side by side.

Do stablecoin pairs have impermanent loss?

Yes, but a negligible one while both pegs hold: a 10 percent divergence gives r = 0.9 and a loss of 0.14 percent. The risk is not the day-to-day drift, it is the depeg. A stablecoin that loses half its value takes the pair to r = 0.5 and the same 5.72 percent as any doubling, on top of the fact that you now hold mostly the broken token.

Can I avoid impermanent loss entirely?

Not in a constant-product pool holding two assets whose prices can diverge — the loss is the mechanism, not a defect. You can shrink it by pairing assets that move together, which keeps r near 1, and some protocols offer single-sided positions where a counterparty absorbs the divergence for a price. The only genuinely zero-loss case is a ratio that ends exactly where it started, and you cannot arrange that in advance.