What Is Impermanent Loss in Crypto? Learn & Avoid Risks

If you're exploring decentralized finance (DeFi) and have contributed to a liquidity pool, you've likely heard the term "impermanent loss." It's a key concept that every crypto investor should understand to safeguard their investments.  
Impermanent loss happens when the value of the assets you've deposited into a liquidity pool goes down compared to holding them outside the pool. This can be a challenging risk to manage, even for experienced investors, making it essential for new and seasoned crypto users to understand its impact.  
In this guide, we'll break down impermanent loss, how it occurs, and practical strategies to reduce exposure. Our goal is to give you the knowledge you need to make confident, informed decisions as you navigate the world of crypto trading.
 

Understanding impermanent loss is crucial for anyone involved in staking or using liquidity pools, as it helps evaluate the risks associated with sharing liquidity on open platforms. Thus, it’s essential to make informed decisions while being able to maximize your returns without jeopardizing your assets.
Impermanent loss happens when one of your assets in a liquidity pool is worth less than if you had simply held onto it. Here's an example: imagine you contribute $1,000 worth of ETH and $1,000 worth of BTC to a liquidity pool. Over time, if ETH increases in value compared to BTC, the value of ETH locked in the pool would decrease than if you had kept it outside the pool. This difference in value is what's referred to as impermanent loss.
The term "impermanent" can be a bit misleading, as it suggests the loss is temporary; however, the loss that occurs can possibly be reversed under certain market conditions and could also become permanent if not carefully managed. It's important to know that there's no guarantee your earnings from providing liquidity will fully offset potential losses.
 

To understand impermanent loss, it’s important to familiarize yourself with liquidity pools and what they mean in crypto. A liquidity pool is similar to a shared pot of funds, which are locked in a smart contract and designed to enable decentralized exchanges to provide peer-to-peer transfers. In essence, liquidity pools provide the juice for one part of the DeFi space to take place.
These pools depend on liquidity providers (LPs)—users who contribute their own funds to keep trades running smoothly and reduce price fluctuations. In most cases, liquidity pools have a 50/50 balance of a trading pool - for example, 50 % is in ETH while the other 50% is in USDT. To that end, DeFi protocols incentivize users to add liquidity to their platform and earn a portion of the transaction fees generated by traders exchanging tokens.
Thus, liquidity pools allow users to earn trading fees and tokens because of them providing liquidity. However, they come with a risk - the biggest being impermanent loss due to locked funds.
Nonetheless, liquidity pools are part of the foundation of the DeFi space and provide the utmost utility to any DEX users who might have encountered or used them. 
 

Impermanent loss occurs when the price of the tokens in the pool fluctuates asymmetrically after a user has made a deposit.
Imagine you contribute $1,000 worth of ETH and $1,000 worth of USDT to a pool. Let's say ETH's value increases by 50% while USDT remains stable. The automated function of the pool adjusts the token ratios to maintain its balance, meaning you'll end up holding less ETH than you initially deposited.  
If you had chosen to simply hold the assets outside the pool, your ETH's higher value would have left you with more value than your return from the pool. The "loss" occurs because the trading fees you earn from the pool may not offset the difference.  
This loss is called "impermanent" because it only materializes if you withdraw your funds while there's a price discrepancy. If the asset prices return to their initial state, the loss could disappear. However, that's not always guaranteed.  
 
 

Calculating impermanent loss may sound complicated, but tools and formulas can simplify this. Here's a quick overview of the mathematical concept behind it.  
Impermanent loss occurs due to the difference in portfolio value, excluding fees, before and after price fluctuations of the assets. One formula for impermanent loss in percentage terms is:
 
IL(%) = 2 × √(price ratio) / (1 + price ratio) - 1  

For example:

• If the price of Token A increases by 25% and no change for Token B, you might calculate the difference and see an impermanent loss of approximately 0.6%.  
• Tools such as online impermanent loss calculators can simplify these computations. Many apps even help provide real-time calculators to assist liquidity providers in evaluating potential risks.  
   

While impermanent loss is common in DeFi, there are smart strategies to minimize its impact on your portfolio.  

Use Stablecoin Pairs  
Providing liquidity to stablecoin-based pools (e.g., USDT/USDC) can significantly reduce price fluctuations since both tokens maintain relatively stable values. This minimizes the chance of experiencing impermanent loss while still allowing LPs to earn transaction fees. Additionally, these pools offer a safer option for those looking to engage in DeFi without exposure to highly volatile assets.

Invest Only a Portion of Your Assets  
Instead of committing your entire portfolio to a liquidity pool, consider investing only a portion you're comfortable risking. This approach helps mitigate potential losses while ensuring that a portion of your holdings remain outside of the liquidity pool. By maintaining this balance, you can participate in opportunities for growth without exposing yourself to unnecessary financial risk. While being in a liquidity pool (LP) does involve risk—especially with the potential for locked liquidity and the inability to withdraw until certain conditions are met—holding crypto assets also carries its own risks. However, the advantage of holding assets outside an LP is that you have immediate access to them. Moreover, you can reduce unnecessary financial risk by holding stablecoins, which provide a more secure alternative to volatile assets. Remember, a diversified and well-thought-out strategy is key to long-term success.

Avoid volatile pairs  
Pairs with high volatility, such as those involving cryptocurrencies or newly launched tokens, are significantly more prone to impermanent loss. Cryptocurrencies, by nature, are volatile compared to stablecoins—any crypto asset can fluctuate widely, while stablecoins maintain a consistent value, even if Bitcoin or other major cryptocurrencies experience a downturn. This volatility can lead to potential losses when compared to simply holding the assets. If your goal is to minimize exposure to impermanent loss, it's wise to steer clear of these volatile pairs and instead focus on more stable options, like stablecoins, that carry less risk

Test Automated Market Makers  
Automated market makers (AMMs) like Uniswap or 1Inch have varying algorithms in place that help mitigate a impermanent loss. Some newer AMMs include features designed to mitigate loss, such as concentrated liquidity or advanced price curve models. Test multiple AMMs to understand how all their algorithms work, and be cautious with how much you invest until you discover what works best for the type of assets you choose to deploy.

Try New Liquidity Pools  
Research emerging liquidity pools with favourable fee structures or lower impermanent loss rates. Consider entering lower liquidity pools, as they can offer a larger share of the pool and higher rewards through commissions for providing liquidity—potentially offsetting or even covering impermanent loss. Investing in pools with high fees and attractive APYs could help reduce impermanent loss, but only if the assets are not highly volatile or if the volatility of the pair is symmetrical. Be mindful, though, to choose pools with sufficient liquidity and robust security.  
 

What Is the Meaning of Impermanent Loss?  
Impermanent loss refers to the temporary reduction in value a liquidity provider might experience when token prices fluctuate. It's called "impermanent" because the loss can be reversed if token prices return to their original levels.
  
Can You Recover from Impermanent Loss?  
Yes, it's possible to recover impermanent losses if the asset prices stabilize or revert to their initial value. Additionally, the transaction fees earned during your time in the liquidity pool may offset some of the loss. However, some losses may become permanent if you withdraw while the prices remain unfavourable.  

Is Impermanent Loss Permanent?  
Impermanent loss isn't always permanent. If you wait for prices to stabilize, the loss may recover. However, withdrawing assets while the price difference remains will lock in the loss, making it permanent. Timing matters to avoid realizing impermanent loss in liquidity pools.
 

Understanding impermanent loss is just one piece of the puzzle when navigating the fast-moving DeFi landscape. At Ndax, we provide Canadian traders with the tools and insights they need to succeed in the crypto world. Whether you're looking to trade, earn, or diversify your portfolio, our platform simplifies it all.
Sign up for Ndax today and take confident steps toward becoming a more informed crypto investor.