What Is Impermanent Loss?
Impermanent loss (IL) is the difference in value between holding tokens in a liquidity pool versus simply holding them in your wallet. It occurs when the price ratio of tokens in the pool changes from when you deposited. The loss is "impermanent" because it reverses if prices return to the original ratio.
How Impermanent Loss Works
When you provide liquidity to an AMM pool (e.g., 50% ETH / 50% USDC), the pool automatically rebalances as prices change. If ETH doubles in price, the pool algorithm sells ETH and buys USDC to maintain the ratio. You end up with less ETH and more USDC than if you had simply held. The difference is your impermanent loss.
A 2x price change in one token results in roughly 5.7% IL. A 5x change results in roughly 25.5% IL.
Why It Matters for Traders
IL is the primary risk for DeFi liquidity providers. It must be weighed against trading fee income and farming rewards. In volatile markets, IL can exceed earned fees, making the LP position net negative. Concentrated liquidity positions (Uniswap V3) amplify both fees earned and impermanent loss, requiring active management.