What Is Impermanent Loss and How to Avoid It?
Participating in cryptocurrency liquidity pools can yield substantial returns, but it also carries the risk of impermanent losses. Understanding how to avoid impermanent loss is key to preserving your profits and mitigating potential setbacks. In this article, we’ll examine what impermanent losses are, explore causes of impermanent loss, and discuss practical strategies to help you safeguard your gains.
What Is Impermanent Loss in Crypto?
Impermanent loss is a risk faced by users of cryptocurrency liquidity pools when the relative prices of the pooled crypto assets shift. Essentially, if the tokens you’ve contributed deviate from crypto price ratios, you could face a temporary loss. Should you withdraw your assets before prices stabilize and return to their original values, this loss becomes more tangible. The greater the price fluctuations, the higher the likelihood of incurring impermanent losses.
How Does Impermanent Loss Occur?
An impermanent loss in cryptocurrency arises when the assets you’ve contributed to a liquidity pool change in value relative to one another. For instance, if you deposit two cryptocurrencies and one appreciates while the other depreciates, the pool automatically rebalances to maintain a fixed ratio. This mechanism can leave you with a lower overall value than if you had simply held each asset in your crypto wallet.
If those assets return to their original prices, the impermanent loss effectively disappears. However, if the price shifts are substantial and the fees from providing liquidity don’t offset them, the loss can become significant.
How to Calculate Impermanent Loss?
To illustrate how impermanent loss in DeFi is calculated, consider an example involving a liquidity pool made up of Bitcoin (BTC) and Ethereum (ETH). Let’s say you add 1 BTC and 10 ETH when the exchange rate is 1 BTC = 10 ETH, meaning your total deposit is 1 BTC + 10 ETH.
So, how impermanent loss works? Suppose ETH’s price rises by 50%, adjusting the rate to 1 BTC = 15 ETH. Because liquidity pools aim to keep the dollar value of each asset in balance, the system automatically rebalances your holdings, giving you fewer ETH and more BTC. This adjustment maintains equal value across both assets in the pool but can create impermanent loss in liquidity pools if you withdraw at this point, before prices have a chance to stabilize.
To calculate impermanent loss, you can use the impermanent loss formula:
Impermanent Loss (%) = 2 * sqrt(P) / (1 + P) – 1
Where P is the percentage change in price. In this case, P = 0.5 because the price of ETH increased by 50%.
Non-constant loss (%) = 2 * sqrt(0.5) / (1 + 0.5) – 1
Non-constant loss (%) ≈ 2 * 0.7071 / 1.5 – 1
Non-constant loss (%) ≈ 1.4142 / 1.5 – 1
Non-constant loss (%) ≈ 0.9428 – 1
Non-constant loss (%) ≈ -0.0572 or -5.72%.
As a result, your holdings in the liquidity pool are now 5.72% less valuable than they would be if you had simply kept them in your wallet.
Table of losses as a function of price change
| Price change (%) | Impermanent Loss (%) |
| 10% | 0.48% |
| 25% | 1.61% |
| 50% | 4.17% |
| 100% | 10% |
| 200% | 20% |
Impermanent Loss Graph
Factors Influencing Impermanent Loss
The magnitude of impermanent loss is influenced by several factors that can substantially affect your overall returns when providing liquidity. Let’s explore the key ones:
Cryptocurrency volatility
Volatility is one of the primary drivers of impermanent loss. When one asset in the pool experiences a significant price swing, it disrupts the balance of the pool and can result in impermanent loss. The higher the volatility, the greater the likelihood that one of the assets will diverge sharply from its original price.
How do AMM algorithms balance the price?
Automated market makers (AMMs) employ specialized algorithms to keep cryptocurrency pools balanced. The most widely used model is the “x * y = k” formula, where x and y represent the quantities of two different tokens, and k remains constant. Smart contracts running these pools automatically recalculate and redistribute assets as market prices fluctuate. Whenever one token’s price shifts, the algorithm adjusts the asset allocation, potentially exposing liquidity providers to impermanent loss.
Time in the pool
The duration of your participation in a liquidity pool also influences crypto impermanent loss. If you keep your assets in the pool for an extended period and the prices of its underlying cryptocurrencies experience major fluctuations, the probability of incurring impermanent loss rises. However, withdrawing your holdings before drastic price movements occur can often minimize—or even eliminate—this risk.
Strategies to Minimize Impermanent Loss
To help mitigate impermanent losses and optimize your liquidity provision strategy, explore the following impermanent loss strategies:
- Use Stablecoins (e.g., USDT/USDC): One of the simplest ways to reduce volatility risk is by pairing stablecoins such as USDT or USDC. Because these tokens are pegged to the U.S. dollar, their prices usually remain steady, minimizing impermanent loss caused by price divergence.
- Diversify Liquidity Across Different Pools: Spreading your assets across multiple liquidity pools helps distribute risk, which is vital for preventing impermanent loss. For example, you can combine stablecoin pairs with more volatile assets, ensuring that sudden price swings in one pool are less likely to severely impact your overall returns.
- Factor in Trading Commission Revenue: When assessing impermanent losses, be sure to include the fees you earn from trades within the pool. High trading volume can significantly boost fee income, helping to offset potential losses and improve the profitability of your liquidity positions.
- Leverage Pools with Non-Standard Proportions (e.g., 80/20 on Balancer): Platforms like Balancer allow you to create pools that deviate from the traditional 50/50 split, such as 80/20 or 70/30 ratios. If one asset is notably more volatile than the other, increasing the share of a stable cryptocurrency can help mitigate impermanent losses by limiting exposure to drastic price fluctuations.
Tools and Calculators for Estimating Impermanent Loss
There are several tools available to help you estimate impermanent loss due to price volatility:
- Impermanent Loss Calculator (x * y = k): A straightforward resource that uses the Automatic Market Maker (AMM) formula to factor in price fluctuations. It shows how shifts in asset prices within a pool may affect your balance and is recognized as one of the most popular and user-friendly calculators available.
- Uniswap Impermanent Loss Calculator: The Uniswap platform provides its own calculator, enabling users to estimate potential losses for any token pair. It’s particularly useful if one asset in the pair is prone to significant price swings relative to the other.
- DeFi Saver – Impermanent Loss Calculation: DeFi Saver’s tool helps users calculate impermanent losses across various DeFi platforms. By incorporating trading fees into its calculations, it offers a more accurate assessment of potential risks and returns.
- Vesper Finance – Impermanent Loss Calculator: Vesper’s calculator analyzes price changes to show how providing liquidity in a pool can influence your investment in real time. This helps you gauge the impact of shifting market conditions on your overall returns.
- Yieldwatch – Loss Calculator: Ideal for those active in multiple liquidity pools, Yieldwatch centralizes data from different DeFi protocols, offering a convenient overview of impermanent losses across various platforms.
- Balancer Pool Analyzer: Balancer’s specialized tool evaluates pools with non-standard asset proportions (e.g., 80/20), showing how these configurations may affect impermanent losses compared to traditional 50/50 splits.
Real-World Case Studies of Impermanent Loss
On Uniswap, contributing liquidity to a pool (e.g., ETH/USDT) involves constantly rebalancing assets whenever ETH’s price fluctuates. If ETH’s value rises, the pool automatically sells off some of your ETH to maintain a 50/50 ratio, leading to impermanent loss—even though ETH’s price has gone up.
On the other hand, Balancer permits the creation of pools with custom asset allocations, such as an 80/20 split. By designating a larger share of the pool to a more stable asset (e.g., USDT), this approach helps mitigate the impact of price swings and typically results in lower liquidity pool impermanent loss compared to conventional 50/50 pools.
Long-Term vs Short-Term Liquidity Provision: When Is IL Less Dangerous?
Impermanent loss (IL) becomes less significant over the long run when trading fees can offset potential losses. However, in the short term—especially amid dramatic price swings—IL can be more pronounced. It effectively disappears if prices revert to their original levels.
For those looking to steer clear of IL and the inherent volatility of DeFi platforms, simply holding (HODL) assets in a wallet may be a safer alternative. By not entering a liquidity pool, you avoid the risk of shifting token proportions that can lead to impermanent losses.
What strategies do experienced traders use?
- Liquidity Diversification: Spreading your liquidity across multiple pools with varying volatility levels—for example, those featuring stablecoins or lower-volatility pairs—helps mitigate the risk of impermanent loss (IL). Examining examples of impermanent loss in different pools can further illustrate how volatility impacts overall returns and guide more informed decision-making.
- Choosing Stable Pairs: Seasoned traders frequently opt for stable pairs, such as USDT/USDC, to minimize IL. These pairs tend to be less susceptible to large price swings, making them more predictable in terms of returns.
- Using Non-Standard Proportions: Pools configured with ratios like 80/20 or 70/30 can substantially reduce IL by allocating a larger share of the pool to more stable cryptocurrencies, thereby diminishing the effects of market volatility.
- Active Monitoring and Reallocation: Savvy liquidity providers track price fluctuations closely and shift their funds between pools as market conditions evolve. This proactive approach helps them capitalize on favorable trends while reducing exposure to impermanent loss.
Checklist: What to Consider Before Entering Liquidity?
Before committing liquidity on a decentralized exchange (DEX), be sure to weigh the following considerations:
- Pool Selection: Evaluate both the liquidity and volatility of the tokens involved to balance risk and reward.
- Impermanent Loss Risks: Understand how price fluctuations can cause impermanent losses (IL) and potentially chip away at your gains.
- Commission Income: Factor in expected fee earnings, making sure they can sufficiently offset the impermanent loss risk.
- Diversification: Spread your capital across several pools to mitigate exposure, including those that involve stablecoins or more stable trading pairs.
Conclusion
Unpredictable losses are an inherent aspect of providing liquidity in the DeFi space. For beginners, understanding impermanent loss early on is crucial, as it enables more effective risk management. By choosing stable assets and diversifying, you can bolster returns while mitigating the impact of market volatility.
FAQ
Impermanent loss arises when the relative prices of the tokens in a liquidity pool diverge, resulting in your share being less valuable than if you’d simply held each asset separately.
No. You can’t entirely eliminate impermanent loss, but you can reduce it by opting for stable pairs, spreading your liquidity across various pools, or choosing lower-volatility pools.
Yes. You may recoup the loss if the prices of the pooled assets revert to their original ratios, or if trading fees generated by the pool offset the dip.
Generally, the most profitable options are those featuring high trading volume and lower volatility, such as stablecoin pools (e.g., USDT/USDC) on popular platforms like Uniswap, Balancer, or Curve.
Impermanent loss vanishes once the assets’ prices realign with their values at the time of your initial deposit.
Yes, it can be worthwhile. If the trading commissions and additional rewards surpass the drawbacks of impermanent loss—and especially if you plan to remain in the pool for an extended period—providing liquidity may prove profitable.
