What is impermanent loss in simple terms?

Impermanent loss is the temporary loss of funds that liquidity providers experience when the price ratio of their deposited tokens changes compared to when they deposited them. It's called 'impermanent' because the loss only becomes permanent if you withdraw your liquidity.

How much impermanent loss can I expect?

Impermanent loss depends on price changes. A 25% price change results in about 0.6% loss, 50% change causes 2% loss, 100% change leads to 5.7% loss, and 500% change results in 25.5% impermanent loss.

Can I avoid impermanent loss completely?

You can minimize but not completely avoid impermanent loss. Strategies include choosing stable pairs, using single-asset staking, selecting pools with high trading fees, and using impermanent loss protection protocols.

Is impermanent loss tax deductible?

Tax treatment varies by jurisdiction. In many countries, impermanent loss may be considered a capital loss when you withdraw liquidity, but you should consult with a tax professional familiar with crypto regulations in your area.

Impermanent Loss Guide: What It Is and How to Minimise It (2025)

Master the concept of impermanent loss in DeFi. Learn what causes it, how to calculate potential losses, and proven strategies to minimise risk while earning yield from liquidity providing.

What Is Impermanent Loss?

Impermanent loss is a temporary decrease in the dollar value of your cryptocurrency holdings when you provide liquidity to automated market makers (AMMs) like Uniswap, SushiSwap, or PancakeSwap, compared to simply holding the tokens in your wallet.

The term "impermanent" is somewhat misleading because:

The loss only becomes "permanent" when you withdraw your liquidity
If token prices return to their original ratio, the loss disappears
However, in practice, prices rarely return to exact original ratios

Why Does Impermanent Loss Occur?

Impermanent loss happens because AMMs use mathematical formulas to maintain token ratios in liquidity pools. When external market prices change, arbitrageurs trade against your pool to profit from price differences, effectively buying your cheaper tokens and selling you more expensive ones.

This mechanism ensures pools stay balanced, but means liquidity providers experience losses when token prices diverge significantly from their deposit ratios.

How Impermanent Loss Works

The Mechanics

Let's understand impermanent loss through a simple example:

Initial Deposit:

You deposit $1,000 worth of ETH and $1,000 worth of USDC
ETH price: $2,000, so you deposit 0.5 ETH + 1,000 USDC
Total deposit: $2,000

Price Change Scenario:

ETH price doubles to $4,000
Arbitrageurs buy ETH from your pool until prices balance
Your pool now contains approximately 0.354 ETH + 1,414 USDC
Total value: $2,828 (0.354 × $4,000 + $1,414)

Comparison:

If you had just held: 0.5 ETH + 1,000 USDC = $3,000
Pool value: $2,828
Impermanent loss: $172 (5.7%)

The Mathematical Formula

For a 50/50 pool, impermanent loss can be calculated as:

IL = 2 × √(price_ratio) / (1 + price_ratio) - 1

Where price_ratio is the new price divided by the original price of one token relative to the other.

Calculating Impermanent Loss

Impermanent Loss at Different Price Changes

Price Change	Impermanent Loss	Example
1.25x (25% increase)	0.6%	ETH: $2,000 → $2,500
1.5x (50% increase)	2.0%	ETH: $2,000 → $3,000
2x (100% increase)	5.7%	ETH: $2,000 → $4,000
5x (400% increase)	25.5%	ETH: $2,000 → $10,000
10x (900% increase)	42.3%	ETH: $2,000 → $20,000

Online Calculators

Several tools can help you calculate impermanent loss:

DeFiPulse IL Calculator: Simple interface for quick calculations
CoinGecko IL Calculator: Supports multiple pool types
APY.vision: Real-time tracking of your positions
Zapper.fi: Portfolio tracking with IL monitoring

Factors Affecting Impermanent Loss

Price Volatility: Higher volatility increases potential loss
Pool Ratio: 50/50 pools have different IL than 80/20 pools
Time Duration: Longer exposure increases risk
Token Correlation: Correlated tokens have lower IL risk

Real-World Examples

Example 1: ETH/USDC Pool During Bull Market

Scenario: You provide liquidity to the ETH/USDC pool in September 2024

Initial deposit: 1 ETH ($2,400) + 2,400 USDC
ETH rises to $4,000 by March 2024
Your pool position: ~0.775 ETH + 3,098 USDC = $6,198
Holding strategy: 1 ETH + 2,400 USDC = $6,400
Impermanent loss: $202 (3.2%)
Trading fees earned: ~$150 over 2 months
Net result: -$52 compared to holding

Example 2: Stablecoin Pool Success

Scenario: USDC/USDT pool on Curve Finance

Initial deposit: $5,000 USDC + $5,000 USDT
Price stability: Minimal price divergence over 6 months
Impermanent loss: 0.1%
Trading fees + CRV rewards: ~8% APY
Result: Significant outperformance vs. holding

Example 3: High-Risk Altcoin Pool

Scenario: DOGE/ETH pool during meme coin rally

Initial deposit: $1,000 DOGE + $1,000 ETH
DOGE pumps 500% while ETH stays stable
Impermanent loss: ~25%
High trading fees: 15% over 1 month
Net result: Still significant loss vs. holding DOGE

Strategies to Minimize Impermanent Loss

1. Choose Stable or Correlated Pairs

Stablecoin pairs: USDC/USDT, DAI/USDC
Correlated assets: ETH/stETH, BTC/WBTC
Same-protocol tokens: UNI/SUSHI (both DEX tokens)

2. Use Weighted Pools

Instead of 50/50 pools, consider 80/20 or other weighted ratios:

Balancer offers various weight combinations
80/20 pools have significantly lower impermanent loss
You maintain more exposure to your preferred asset

3. Focus on High-Fee Pools

Target pools with 0.3% or higher trading fees
Volatile pairs often generate more trading volume
Fee income can offset impermanent loss

4. Single-Asset Staking

Consider alternatives that don't involve impermanent loss:

Ethereum staking (no IL risk)
Single-asset lending on Aave
Centralized staking on Binance

5. Time Your Entry and Exit

Enter during high volatility periods (more fees)
Exit before major price movements if predictable
Monitor market conditions and news

6. Use Impermanent Loss Protection

Some protocols offer IL protection:

Bancor: 100% IL protection after 100 days
Thorchain: Asymmetric liquidity provision
Balancer: Smart pool strategies

When Liquidity Providing Is Worth It

Favorable Conditions

High trading volume: More fees to offset IL
Stable price ratios: Minimal divergence expected
Additional rewards: Governance tokens, farming incentives
Short-term strategy: Quick entry/exit during high-fee periods

Risk/Reward Analysis

Before providing liquidity, calculate:

Expected trading fees (historical data)
Additional reward tokens and their value
Potential impermanent loss scenarios
Gas costs for entry and exit

Break-Even Analysis

For a position to be profitable, total rewards must exceed:

Impermanent loss
Gas fees for transactions
Opportunity cost of holding

Use this formula: Profit = (Trading Fees + Rewards) - (Impermanent Loss + Gas Costs)

Impermanent Loss Protection Protocols

Bancor V3

Protection: 100% IL protection after 100 days
Mechanism: Protocol mints/burns BNT to compensate
Supported tokens: Major assets like ETH, WBTC, LINK
Trade-off: Lower yields compared to unprotected pools

Thorchain

Protection: Asymmetric liquidity provision
Mechanism: Provide single assets, protocol handles pairing
Coverage: Cross-chain assets (BTC, ETH, BNB)
Consideration: Protocol risk and complexity

Balancer Smart Pools

Protection: Dynamic weight adjustment
Mechanism: Automated rebalancing reduces IL
Flexibility: Custom strategies and parameters
Requirement: Higher technical knowledge

Insurance Options

Nexus Mutual: DeFi protocol coverage
Cover Protocol: Specific IL insurance products
InsurAce: Comprehensive DeFi insurance

Tax Implications

Tax Events in Liquidity Providing

Deposit: May be taxable swap in some jurisdictions
Fee earnings: Usually taxable as income
Reward tokens: Taxable at fair market value when received
Withdrawal: Capital gains/losses on token amounts
Impermanent loss: May be deductible capital loss

Record Keeping

Maintain detailed records of:

Initial deposit amounts and values
All fee earnings and reward distributions
Token prices at deposit and withdrawal
Gas fees for all transactions
Final withdrawal amounts and values

Tax Tools

Koinly: DeFi transaction tracking
CoinTracker: Comprehensive crypto tax software
TokenTax: Specialized DeFi tax calculations
Accointing: Portfolio and tax management

Important: Tax laws vary by jurisdiction and are constantly evolving. Consult with a qualified tax professional familiar with cryptocurrency regulations in your area.

Best Practices for Liquidity Providers

Risk Management

Start small: Test with small amounts first
Diversify: Don't put all funds in one pool
Monitor actively: Track positions and market conditions
Set limits: Define maximum acceptable loss levels

Pool Selection Criteria

Total Value Locked (TVL): Higher TVL indicates stability
Trading volume: Consistent volume generates fees
Protocol reputation: Stick to established platforms
Smart contract audits: Verify security assessments

Monitoring Tools

APY.vision: Real-time IL tracking
Zapper.fi: Portfolio overview and analytics
DeBank: Multi-protocol position tracking
Dune Analytics: Custom dashboards and metrics

Exit Strategies

Profit targets: Set specific return goals
Loss limits: Define maximum acceptable losses
Time limits: Set maximum position duration
Market conditions: Exit before major volatility

Platform Recommendations

Beginners: Uniswap (simple interface)
Stablecoins: Curve Finance (low IL risk)
Advanced users: Uniswap V3 (flexible ratios)
Cross-chain: DeFi Risk Management

Frequently Asked Questions

What is impermanent loss in simple terms?: Impermanent loss is the temporary loss of funds that liquidity providers experience when the price ratio of their deposited tokens changes compared to when they deposited them. It's called 'impermanent' because the loss only becomes permanent if you withdraw your liquidity.
How much impermanent loss can I expect?: Impermanent loss depends on price changes. A 25% price change results in about 0.6% loss, a 50% change causes 2% loss, a 100% change leads to 5.7% loss, and a 500% change results in 25.5% impermanent loss.
Can I avoid impermanent loss altogether?: You can minimise but not altogether avoid impermanent loss. Strategies include choosing stable pairs, using single-asset staking, selecting pools with high trading fees, and using impermanent loss protection protocols.
Is impermanent loss tax deductible?: Tax treatment varies by jurisdiction. In many countries, impermanent loss may be considered a capital loss when you withdraw liquidity; however, it is recommended to consult with a tax professional familiar with cryptocurrency regulations in your area.
Which pools have the lowest impermanent loss risk?: Stablecoin pairs (USDC/USDT) and highly correlated assets (ETH/stETH) have the lowest impermanent loss risk. Weighted pools (80/20) also reduce IL compared to 50/50 pools.
How do trading fees offset impermanent loss?: Trading fees are distributed to liquidity providers proportionally. High-volume pools generate more fees, which can offset impermanent loss. However, high volume often correlates with high volatility and higher IL risk.
What's the difference between impermanent loss and permanent loss?: Impermanent loss is unrealised and can be recovered if token prices return to original ratios. Permanent loss occurs when you withdraw liquidity, crystallising the loss. Smart contract failures or rug pulls cause permanent, unrecoverable losses.
Should beginners provide liquidity to DeFi pools?: Beginners should start with small amounts in stable pairs or use single-asset staking first. Understanding impermanent loss mechanics is crucial before providing liquidity to volatile pairs.