Impermanent Loss (Detailed)

Impermanent loss is the cost of providing liquidity to an automated market maker (AMM). When you deposit two tokens into a liquidity pool, the AMM rebalances your position as prices change. If one token's price increases significantly relative to the other, you end up with more of the cheaper token and less of the expensive one — less total value than simply holding.

A concrete example: you deposit $5,000 of ETH and $5,000 of USDC into a liquidity pool ($10,000 total). If ETH doubles in price, a simple hold would be worth $15,000 ($10,000 ETH + $5,000 USDC). But the pool automatically rebalances, leaving you with approximately $14,142. The $858 difference is the impermanent loss — about 5.7%.

The loss is called "impermanent" because it reverses if prices return to their original ratio. If ETH drops back to its original price, the loss disappears. However, if you withdraw while prices are divergent, the loss becomes permanent. In practice, many liquidity providers withdraw during divergence, making the "impermanent" label misleading.

Impermanent loss increases with price divergence. A 25% price change causes ~0.6% loss. A 2x price change causes ~5.7% loss. A 5x change causes ~25.5% loss. Pools with highly correlated assets (USDC/USDT) have minimal impermanent loss. Pools with volatile pairings (ETH/SHIB) have extreme exposure.

To be profitable as a liquidity provider, trading fees earned must exceed impermanent loss. High-volume pools on popular pairs can generate 20-50%+ APR in fees, potentially outweighing the impermanent loss. Low-volume pools may not generate enough fees to compensate, resulting in a net loss compared to simply holding the tokens.