How Impermanent Loss Affects Your Liquidity Pools: What Every Provider Must Know

Imagine lending your assets to a trusted friend, only to get them back reshuffled and slightly devalued - even though they didn’t steal anything. That’s what impermanent loss feels like in the world of DeFi.

It’s not a scam, a hack, or fraud - it’s a built-in risk of being a liquidity provider on decentralized exchanges (DEXs). You earn rewards by supplying tokens to liquidity pools, but you also silently expose your assets to this often-misunderstood risk.

In this guide, we’ll break down what impermanent loss is, how it works, and most importantly, how to calculate and avoid it using real examples and smart strategies. Whether you're a DeFi beginner or a seasoned LP, understanding this concept is key to making better, more profitable decisions.

What Is Impermanent Loss?

Let's start with the basic definition; impermanent loss is a common phenomenon in AMMs that rely on algorithms to manage liquidity and trades. It occurs when you, as a liquidity provider, add liquidity to any decentralized exchange and the price of tokens you deposited changes as compared to when you deposited them.

Why it is known as 'impermanent' loss is also very interesting. It is because the loss is not locked unless you withdraw your tokens while the prices are still unbalanced. In case the token prices return to their original state before you withdraw, the loss can shrink or disappear entirely.

How Does Impermanent Loss Happen?

Now let's talk about how impermanent loss in liquidity pools happens.  

• Tokens are deposited: As a liquidity provider, you are required to provide two sets of assets (like USDC and ETH) of equal value into a liquidity pool.  
• Price shifts cause asset ratio to rebalance: If the price of a token falls or rises, the pool automatically adjusts the ratio of tokens to maintain balance.
• Arbitrage traders create the discrepancy: Traders take advantage of these price differences between the pool and the open market. This causes your share of the pool to shift.
• Final withdrawal = less than HODLing: When you withdraw, the total value of your assets is often lower than if you had just held them in your wallet.

So, now the question will be how you can calculate an impermanent loss. As an example, see the following.

• Say, you provide 1 ETH ($2,000) and 2,000 DAI into a liquidity pool. So, the total value will be $4,000.
• Now, assume ETH rises to $3,000. The liquidity pool will automatically adjust the balance - reducing your ETH share and increasing your DAI share.
• As a result, you now hold fewer ETH and more DAI, even though the total pool value increased.

So, basically if you had just held 1 ETH and 2,000 DAI, you’d now have $5,000. But due to the rebalancing, your share might be worth only around $4,800.  

That $200 difference is your impermanent loss.

You can use tools like impermanentloss.app or dailydefi.org to estimate loss based on price changes using an impermanent loss calculator.

Factors That Influence Impermanent Loss

There are many factors that influence the impermanent loss in defi that you may face. These factors include:

Volatility: Bigger Swings = Greater Risk

The impermanent loss is directly tied to price divergence between the tokens of the liquidity pair that you have provided. The greater the volatility between the pair, the more pool needs to rebalance. If one token doubles in value while the other stays the same, you often suffer great liquidity pool impermanent loss.

Holding Time: Longer Time = More Exposure

The longer your funds stay in the liquidity pool, the greater the time there is for prices to shift, especially when operating in a volatile market. If prices don't return to their original ratio, the impermanent loss in liquidity pools is more likely to be realized when you withdraw. This helps you gain greater exposure for your liquidity.

Trading Fees: May Offset Loss

Every single trade in the liquidity pool generates a share of fees for the liquidity provider. If the pool you have added token in has higher trading volume and decent fees, the earnings you receive can sometimes outweigh the impermanent loss. Due to this reason, mostly liquidity providers remain in profitable situations despite the impermanent loss.

Market Trends: Bull/bear Cycles Affect the Value

Broader market movements, which are usually out of our control, can either reduce or amplify impermanent loss. An excellent example would be Trump's recent crypto reserve strategy. This resulted in major price fall for many cryptocurrencies including ETH. Moves like this can lower or increase the impermanent loss for you.

When Is Impermanent Loss Not a Major Concern?

While impermanent loss may sound scary at first, there are many situations where it is minimal or even negligible. Some of these instances include:

1. Short-term Liquidity Provision:  

In case you are providing liquidity for a limited period of time (like a promotional period of a token), the chances of extreme price divergence and very low. This strategy also works well in relatively stable markets where token prices don't diverge wildly in a short period.

2. Stablecoin Pools = Stable Returns

One of the best ways to dodge impermanent loss is to provide liquidity for stablecoin pairs, like USDC/DAI. The thing about stablecoin pairs is that since both tokens are pegged at the same value, they don't diverge much. This means the liquidity pools rarely need to rebalance, and the impermanent loss stays close to zero.

3. Correlated Assets:

Investing in liquidity pools for correlated assets also keeps your impermanent loss near to zero. This is because both assets in the pair tend to move together and hence, offer nearly identical price trends. A good example would be ETH and stETH; since stETH is a staked version of ETH, it follows nearly the same pricing, and the risk of large rebalancing losses is reduced significantly.

4. High Incentives Can Offset the Loss:

In some high-volume pools, the fees earned from trades, as well as the bonus incentives offered by certain platforms, can completely offset the impermanent loss. A volatile pair may produce impermanent loss, but if the trading activity is high enough, the pool's rewards can not only cover the impermanent loss but also give you some profit on top.

How to Avoid or Reduce Impermanent Loss

Now that you know what is impermanent loss crypto, you’d understand that it can’t be eliminated entirely. But you can definitely utilize strategies to avoid or reduce its impact. Here is how to avoid impermanent loss:

1. Use Stablecoin Pairs

Use stablecoins, like USDC/DAI or BUSD/USDT, to avoid extreme volatility. Stablecoins are specifically designed to maintain a fixed value so since they rarely diverge, there is a high chance your pool with require minimal rebalancing. These pools offer low risk as well as a steady income fee. However, the yields are typically low, but it is best for risk-averse users

2. Pick Correlated Assets

Correlated tokens tend to move in the same direction. So, if one increases in value, the second tends to move along. For instance, ETH/stETH and WBTC/ BTCB are highly correlated so the chance of significant price divergence, and thus IL, is lower.

3. Try IL Protection Platforms

Some defi platforms offer built-in impermanent loss insurance which often comes with trade-offs like lock-in periods, lower flexibility, or protocol-specific rules. If you are worried about extensive IL, try these platforms.

4. Earn Extra Rewards

Many liquidity pools offer bonus token incentives for contributing to their liquidity pool. These extra earnings are paid in the platform's native token, and can help you offset your impermanent loss in defi, especially in high-yield opportunities. You can then reinvest your rewards for compound returns.

5. Diversify Pools

Much like traditional investing, diversification helps in the defi world as well. What it means is you can split your liquidity across multiple pools according to the potential impact of impermanent loss. Doing so will help you track performance of each pool individually and reallocate your assets based on returns.

If you're wondering how to calculate impermanent loss before choosing a pool, consider using a reliable impermanent loss formula or online calculators to assess risk based on projected price movements.

Real-World Examples: How Impermanent Loss Affected Popular Pools

So, impermanent loss is not a concern in many cases BUT ... it has played out many times across major defi platforms causing some major losses.

1. Uniswap V2 - ETH/DAI Pool

One of the most referenced impermanent loss cases happened in 2020, with Uniswap V2. During an Etherum's price surge, the liquidity providers of ETH/DAI faced extreme losses. Let’s say a user added 1 ETH ($400 at the time) and 400 DAI into the ETH/DAI pool in mid-2020. ETH's price skyrocketed to 4x times in the next few months and DAI remained at the same point. The AMM rebalanced the pool, converting much of that ETH into DAI...and when the LPs withdrew their funds, they had far less ETH than originally deposited.

2. Bancor v2.1 – Impermanent Loss Protection

To combat the Uniswap V2 issues, Bancor introduced impermanent loss protection, which reimbursed liquidity providers for losses due to price divergence. The condition, however, was to keep their assets in the pool for a set period of time. Therefore, users who deposited tokens like LINK or ETH into Bancor pools saw full protection from impermanent loss after the 'cooldown' period.

3. Curve Finance – Using Stablecoins

Curve Finance has built a strong reputation for minimizing impermanent loss through stablecoin-only pools. Users providing liquidity on Curve typically experience negligible impermanent loss because Curve only offers stablecoin liquidity pools.

Strategies to Recover from Impermanent Loss  

If you have experienced impermanent loss at some point already, know that you can follow some strategies to avoid it in the future. Here are some strategies that you can implement:

1. Hold through market cycles: Impermanent loss only becomes permanent if you withdraw when prices are unbalanced. If the market recovers and tokens revert to their original ratio, losses may shrink or disappear.
2. Let rewards outweigh the loss: Transaction fees, farming rewards, or bonus tokens can compensate for the IL overtime. Some LPs remain in profit even after experiencing impermanent loss.
3. Compare with alternatives: If your LP rewards are still higher than what you’d earn through staking or HODLing, the strategy may still be viable. Risk management is key.

Final Words

Impermanent loss, when explained simply, is not as mysterious or devastating as it sounds - if you understand it upfront. While it’s one of the most common risks in DeFi liquidity provision, it’s also one of the most manageable.

By choosing low-volatility pairs, using impermanent loss calculators, leveraging protection tools, and staying aware of market trends, you can limit your exposure and even turn a profit over time.

If you’re just starting out, experiment with smaller amounts, keep learning, and compare impermanent loss risks against other earning strategies like staking or farming. The key is to stay informed and know your risk tolerance.