Impermanent loss is the most misunderstood risk in DeFi — and the reason a pool's headline yield can mislead. It's the gap between providing liquidity and simply holding the two tokens, when their prices move apart.
Why it happens
An AMM constantly rebalances your pool to keep x · y = k. As one token rises, the pool sells some of it and buys the other to hold the ratio — so you end up with more of the loser and less of the winner than if you'd done nothing. The arbitrageurs who keep the pool's price correct are, in effect, profiting from you.
A simple example
You deposit 1 ETH (at $2,000) and 2,000 USDC — $4,000 total. Now ETH doubles to $4,000:
- If you'd just held: 1 ETH + 2,000 USDC = $6,000.
- As an LP: the pool rebalanced as ETH rose, leaving you roughly 0.707 ETH and 2,828 USDC ≈ $5,657.
The ~$343 difference is impermanent loss. You still made money — you're just behind the holder. Fees earned along the way offset some or all of it.
Why "impermanent"
If the prices return to where they started, the loss disappears — hence "impermanent". But withdraw while they're diverged and it becomes very permanent. The name lulls people; treat it as real.
How to limit it
- Stablecoin or correlated pairs (USDC/USDT, ETH/stETH) barely diverge, so IL is minimal — the most beginner-friendly LP positions.
- High, real fee income can outweigh IL on volatile pairs, but you need genuine volume, not a printed APY.
- Avoid pairing a volatile token with a stablecoin right before a big move — that's where IL bites hardest.
Rule of thumb: the more two tokens can move apart, the more impermanent loss you're underwriting for the fees you collect.
- Reading a pool's APY as guaranteed profit without subtracting impermanent loss.
- LPing a volatile token against a stablecoin right before a large price move.
- Withdrawing during a big divergence, locking in what might have recovered.