Impermanent Loss Explained

Impermanent loss is the most important risk that liquidity providers face, and it is widely misunderstood. It occurs when the price of tokens in your liquidity pool changes relative to when you deposited them, causing your position to be worth less than if you had simply held the tokens in your wallet.

How Impermanent Loss Happens

When you provide liquidity to an AMM pool, the protocol constantly rebalances your position to maintain the mathematical ratio. If Token A rises in price relative to Token B, the AMM sells some of your Token A for Token B to keep the ratio balanced. This means you end up with less of the token that went up and more of the token that went down — the exact opposite of what you'd want.

Consider this example:

1. You deposit 1 ETH ($2,000) and 2,000 USDC into an ETH/USDC pool. Total value: $4,000.
2. ETH price doubles to $4,000. If you had just held, you'd have 1 ETH ($4,000) + 2,000 USDC = $6,000.
3. But in the pool, the AMM rebalanced. You now have approximately 0.707 ETH ($2,828) + 2,828 USDC = $5,657.
4. Impermanent loss: $6,000 - $5,657 = $343 (about 5.7% of what you'd have by just holding).

The Math Behind Impermanent Loss

Impermanent loss depends on the magnitude of price change, not the direction:

Price Change	Impermanent Loss
1.25x (25% change)	0.6%
1.5x (50% change)	2.0%
2x (100% change)	5.7%
3x (200% change)	13.4%
5x (400% change)	25.5%

Why "Impermanent"?

The loss is called "impermanent" because it only becomes permanent if you withdraw your liquidity while the price difference exists. If the prices return to their original ratio, the impermanent loss disappears. However, in practice, prices rarely return to exactly the same ratio — so some degree of loss is usually realized.

When Impermanent Loss Is Minimal

Impermanent loss is lowest in pools where both tokens tend to move together in price:

• Stablecoin pairs: USDC/USDT pools have near-zero impermanent loss because both tokens are pegged to $1.
• Correlated assets: ETH/stETH or BTC/WBTC pools have low impermanent loss because the tokens track each other closely.
• Highest risk: Volatile token/stablecoin pairs (e.g., a small-cap altcoin paired with USDC) can experience massive impermanent loss.

For Sri Lankan DeFi participants, impermanent loss is especially important to understand because it is an invisible cost. Your pool position may show a positive return in dollar terms (from trading fees), while still underperforming a simple buy-and-hold strategy. Always calculate whether the fees you earn exceed the impermanent loss you suffer — otherwise, you're paying for the privilege of providing liquidity.