Impermanent Loss Explained: The Hidden Cost of Providing Liquidity

Impermanent loss is the biggest risk for DeFi liquidity providers. Here is a clear, simple explanation of what it is and how to minimise it.

Impermanent loss (IL) is the difference in value between providing liquidity to a DEX pool versus simply holding the same assets. It occurs because AMMs (Automated Market Makers) maintain a constant ratio between assets — when prices change, the pool automatically rebalances, meaning you end up with more of the falling asset and less of the rising one.

A Simple Example

• You deposit $5,000 ETH and $5,000 USDC into a Uniswap pool
• ETH price doubles. The pool auto-rebalances: you now have ~$7,071 ETH + $7,071 USDC = $14,142
• If you had just HELD: $10,000 ETH + $5,000 USDC = $15,000
• Impermanent loss: $15,000 - $14,142 = $858 (5.7% of your total value)
• It is "impermanent" because if ETH returns to its original price, the loss disappears

How to Minimise Impermanent Loss

• Use stablecoin-only pools (USDC/USDT): both assets same price = zero IL
• Use correlated asset pairs (ETH/stETH, WBTC/ETH): similar price movements reduce IL
• Concentrated liquidity (Uniswap v3): focus liquidity in a price range — higher fees but higher IL if price exits range
• Wide fee pools: 1% fee pools compensate for higher IL assets
• Earn enough in fees: if fees > IL, the position is still profitable overall

Calculating If LP Is Worth It

For any LP position: estimate expected IL based on price correlation, expected trading volume (determines fee income), and time horizon. If fee income exceeds expected IL plus gas costs, the position is profitable. Steyble's LP calculator shows projected IL for different price scenarios before you enter — helping you make an informed decision about whether the yield justifies the IL risk.