Impermanent Loss
DeFi Strategies • Yield Models • Token Income
value erosion from liquidity pool price divergence
Impermanent Loss refers to the temporary reduction in value a liquidity provider (LP) may suffer when contributing assets to a liquidity pool, especially when the prices of those assets diverge significantly. This occurs because AMMs automatically rebalance token ratios, and LPs may end up withdrawing more of the depreciated asset and less of the appreciated one. The loss becomes permanent only if the funds are withdrawn before price convergence.
Use Case: An LP deposits $ETH and $FLR into a pool. If $ETH triples in value while $FLR stays flat, the AMM sells some $ETH to maintain a 50/50 ratio. When the LP exits, they receive more $FLR and less $ETH—resulting in a realized loss compared to holding both tokens separately.
Key Concepts:
- Price Divergence — When paired tokens shift in value relative to each other
- LP Rebalancing — Automated adjustments by AMMs to maintain pool ratios
- IL Curve — A visual representation of loss severity based on divergence
- Realized Loss — When impermanent loss becomes permanent upon withdrawal
- Automated Market Makers — Protocol mechanism that causes IL through constant rebalancing
- AMM — Decentralized exchange model where IL occurs
- Liquidity Pool — Token pair deposits where LPs face IL risk
- LP Tokens — Receipt tokens representing pool share and IL exposure
- Yield Farming — Strategy where IL must be weighed against rewards
- Swap Fee — Trading fees earned that may offset IL
- Slippage Risk — Related trading risk in low-liquidity pools
- DeFi Risk — Broader category including IL exposure
- Stablecoins — Paired assets that minimize IL in stable pools
- DeFi — Ecosystem where IL is a fundamental consideration
Summary: Impermanent loss is a fundamental risk in liquidity provisioning. While trading fees and incentives may offset the loss, LPs in volatile pools can still suffer significant value erosion. Smart timing, stable pairs, and protocol design can help reduce exposure.
How Impermanent Loss Works
the mechanics behind LP value erosion
LP deposits equal value of two tokens • Example: $1000 ETH + $1000 FLR • Pool maintains 50/50 ratio • LP receives LP tokens • Position tracked on-chain
One token appreciates vs the other • ETH doubles, FLR stays flat • Pool ratio now imbalanced • Arbitrageurs see opportunity • Price difference creates pressure
Arbitrageurs buy cheap ETH from pool • Pool sells ETH, receives FLR • Ratio returns to 50/50 by value • LP now holds less ETH, more FLR • Automatic, continuous process
LP withdraws position • Receives more FLR, less ETH • Total value less than if held separately • The “loss” is realized • Fees may or may not offset
IL by Price Divergence
how much you lose at different price changes
IL Mitigation Strategies
reducing exposure to impermanent loss
✓ Choose correlated pairs (ETH/WBTC)
✓ Use stablecoin pairs (USDC/USDT)
✓ Same-asset pools (ETH/stETH)
✓ Lower volatility tokens
✓ Concentrated liquidity ranges
✓ Higher fee tier pools
✓ Enter during low volatility
✓ Exit before major price moves
✓ Avoid new token launches
✓ Monitor divergence metrics
✓ Set IL threshold alerts
✓ Rebalance positions actively
• Concentrated liquidity (Uniswap v3)
• IL protection programs
• Single-sided staking options
• Automated rebalancing vaults
• Range orders
• Dynamic fee pools
• Skip LP entirely—stake native
• Liquid staking (sFLR, stETH)
• Lending protocols
• Holder’s Yield (no IL risk)
• Single-asset vaults
• Yield aggregators
IL vs Fees: The Real Math
when does liquidity provision actually profit?
Fees Earned + Incentives > IL
Example:
• IL from divergence: -5.7%
• Trading fees earned: +8%
• Farm incentives: +12%
• Net result: +14.3% profit
• LP wins despite IL
Fees Earned + Incentives < IL Example:
• IL from divergence: -20%
• Trading fees earned: +3%
• Farm incentives: +10%
• Net result: -7% loss
• Would’ve been better holding
More swaps = more fees
Can offset moderate IL
Example: ETH/USDC
Often profitable
Farm rewards boost yield
Can offset higher IL
Example: New protocol
Check sustainability
Minimal fee generation
IL often exceeds gains
Example: Obscure pairs
Usually unprofitable
When to Avoid Liquidity Provision
situations where IL risk outweighs rewards
✗ Bull market rallies (tokens pumping)
✗ New token launches (high volatility)
✗ Low correlation pairs
✗ Bear market capitulations
✗ Low volume pools (fees don’t offset)
✗ Declining incentive emissions
✓ Sideways/range-bound markets
✓ Stablecoin pairs
✓ Correlated assets (ETH/stETH)
✓ High volume blue-chip pools
✓ Strong incentive programs
✓ Concentrated liquidity (tight range)
IL-Free Yield Alternatives
earn without impermanent loss exposure
Impermanent Loss Checklist
before entering any liquidity position
☐ Calculate IL at 2x, 3x, 5x divergence
☐ Estimate fee income over period
☐ Check incentive sustainability
☐ Assess token correlation
☐ Review pool volume history
☐ Compare to just holding
☐ Prefer correlated pairs
☐ Check fee tier (higher = more income)
☐ Verify pool TVL (liquidity depth)
☐ Research protocol security
☐ Understand withdrawal mechanics
☐ Test with small amount first
☐ Monitor price divergence
☐ Track fees vs IL ratio
☐ Set exit thresholds
☐ Rebalance if needed
☐ Harvest rewards regularly
☐ Document for taxes