If you provide liquidity to a Uniswap-style automated market maker (AMM) pool, impermanent loss is the difference between what your deposited assets would be worth if you simply held them in your wallet versus their value inside the pool when you withdraw. It is called "impermanent" because the loss only becomes permanent if you withdraw while the price is still different from your entry price. If the price returns to your original ratio, the loss disappears. The simplest way to understand this is through a concrete, step-by-step worked example.
The Setup: Your Initial Deposit in a 50/50 Pool
Imagine you want to provide liquidity to a Uniswap V2-style pool for Token A and Token B. The pool always maintains a constant product formula:
x * y = k, where
x is the amount of Token A,
y is the amount of Token B, and
k is a constant. You decide to deposit $1,000 worth of each token, so your total position is worth $2,000.
Your Starting Balances
Let’s say Token A is trading at $1.00 and Token B is also trading at $1.00. To deposit $1,000 of each, you put in:
- 1,000 Token A (worth $1,000)
- 1,000 Token B (worth $1,000)
Your share of the pool is small, but the math works the same regardless of pool size. At this moment, the pool price ratio is 1:1. Your total value is $2,000.
What Happens When Token B Doubles in Price?
Now, suppose external market forces push the price of Token B up to $2.00, while Token A stays at $1.00. On a regular exchange, your 1,000 Token B would now be worth $2,000. If you simply held both tokens, your total portfolio would be worth $3,000 ($1,000 in A + $2,000 in B).
However, the AMM does not hold prices static. Arbitrageurs will buy the underpriced Token B from your pool until the pool’s internal price matches the external market. This changes the balance of tokens you hold.
The New Pool Balance After Arbitrage
Using the constant product formula, the pool must adjust so that the ratio of Token A to Token B equals the new market price of 2:1 (Token B is twice as valuable). The pool will now hold more Token A and fewer Token B. Specifically, the new balances will be:
- 1,414 Token A (approximately)
- 707 Token B (approximately)
Why these numbers? Because 1,414 * 707 ≈ 1,000,000 (your original
k), and the ratio of A to B is 2:1, reflecting the price. Your share of the pool is now these amounts.
Calculating Your Value Inside the Pool vs. Holding
Now let’s compare the two scenarios side by side. This is the core of understanding impermanent loss.
Scenario 1: You Held the Original Tokens
If you never deposited, you would still have 1,000 Token A and 1,000 Token B. At the new prices:
- 1,000 Token A × $1.00 = $1,000
- 1,000 Token B × $2.00 = $2,000
- Total = $3,000
Scenario 2: You Stay in the Pool
With your pool share, you now hold 1,414 Token A and 707 Token B. At the new prices:
- 1,414 Token A × $1.00 = $1,414
- 707 Token B × $2.00 = $1,414
- Total = $2,828
The difference is $3,000 – $2,828 =
$172. That $172 is your impermanent loss. It is not a fee you paid; it is an opportunity cost relative to simply holding.
Why the Loss Is "Impermanent" and How Fees Offset It
The loss is called impermanent because it only exists while the price ratio is different from your entry ratio. If Token B falls back to $1.00, the pool will rebalance back to 1,000 A and 1,000 B, and your value returns to $2,000—no loss at all.
The Role of Trading Fees
Every time someone trades against your pool, you earn a small fee (e.g., 0.3% on Uniswap V2). These fees are added to your liquidity position. Over time, if the pool is active, the cumulative fees can offset or exceed the impermanent loss. In the example above, if you earned more than $172 in fees during the period the price was elevated, you would actually come out ahead.
When Does Impermanent Loss Hurt Most?
The loss is largest when one token’s price moves dramatically relative to the other. A 2x price change causes roughly a 5.7% loss relative to holding. A 3x change causes about a 13% loss. The more volatile the pair, the higher the risk of impermanent loss, which is why stablecoin pairs (like USDC/DAI) are popular for low-risk yield.
Key Takeaways for Liquidity Providers
Here is a quick summary of what this worked example teaches you:
| Factor |
Impact on Impermanent Loss |
| Price divergence |
Greater divergence = larger loss |
| Time in pool |
Longer time = more fees to offset loss |
| Pool volatility |
Higher volatility = higher risk of loss |
| Withdrawal timing |
Withdrawing during divergence locks in the loss |
The practical lesson is not to avoid providing liquidity, but to understand that you are essentially betting on two things: that the pool generates enough trading fees, and that the price ratio does not swing wildly away from your entry point. If you are uncomfortable with the idea of your assets rebalancing into a different mix than you originally deposited, then a simple "hold" strategy may be more suitable. For those who do provide liquidity, monitoring the price ratio and knowing your breakeven fee rate is essential.