Impermanent Loss

Impermanent loss affects anyone who deposits tokens into an automated market maker pool. Because the pool constantly rebalances to keep its pricing formula true, it sells the token that is rising and buys the token that is falling. The provider therefore ends up with less of the winner and more of the loser than if they had just held both tokens in a wallet.

Example: a provider deposits 1 ETH and 2,000 USDC when ETH is 2,000 dollars, a total of 4,000 dollars. ETH then doubles to 4,000 dollars. The pool rebalances to about 0.707 ETH and 2,828 USDC, worth about 5,657 dollars. Simply holding would have been worth 6,000 dollars. The gap of roughly 343 dollars, about 5.7 percent, is the impermanent loss. For a 5x price change the loss is about 25 percent.

The loss is called impermanent because it shrinks if prices return to the original ratio, but it becomes permanent once the provider withdraws. Trading fees earned may offset it, which is why stable pairs like USDC and DAI, where prices barely diverge, are popular for conservative providers.