DeFi Deep Dive
Impermanent Loss
AMMs, lending, yield, impermanent loss, and self-custodial finance.
In this lesson
- What impermanent loss is
- Why it's 'impermanent'
Key takeaways
- 1IL happens when pooled prices diverge vs holding
- 2It shrinks if prices return to the original ratio
- 3Fees must outweigh IL for LPs to profit
Lesson summary
Impermanent loss is the opportunity cost of providing liquidity when pooled asset prices diverge.
Mental model
The core idea behind impermanent loss
Impermanent loss is the opportunity cost of providing liquidity when pooled asset prices diverge. It compares the LP position against simply holding the assets.
- What impermanent loss is
- Why it's 'impermanent'
Mechanics
How to reason about impermanent loss
AMM formulas rebalance the pool as traders arbitrage price changes.
The LP ends up holding more of the underperforming asset and less of the outperforming asset.
Fees can offset the loss, but only if volume and fee income are strong enough.
- IL happens when pooled prices diverge vs holding
- It shrinks if prices return to the original ratio
- Fees must outweigh IL for LPs to profit
Example
Impermanent Loss in practice
If ETH rises sharply against USDC, an ETH/USDC LP has less ETH than they would have had by just holding the original assets.
Common mistakes
Common mistakes with impermanent loss
The word impermanent can mislead users. The loss is only reduced if prices return or fees compensate; otherwise it is economically real.
Risk notes
Staying safe around impermanent loss
High volatility, low fees, concentrated liquidity ranges, and thin pool activity can increase LP underperformance.
- Compare LP result with holding.
- Estimate fee offset.
- Understand what happens if one asset trends hard.
Practice
Practise impermanent loss before moving on
- Compare LP result with holding.
- Estimate fee offset.
- Understand what happens if one asset trends hard.
Review
Key terms
- Arbitrage
- Profiting from the same asset trading at different prices across markets by buying low and selling high simultaneously.
- DeFi
- Decentralized Finance — permissionless, composable financial services built on smart contracts.
- Impermanent Loss
- The loss a liquidity provider faces when pooled asset prices diverge versus simply holding them.
- Liquidity
- How easily an asset can be bought or sold without moving its price much.
- Volatility
- How sharply a price swings over time — higher volatility means higher risk and opportunity.
Source notes
Editorial references
These references are starting points for verifying the mechanisms, risk checks, and product context behind this lesson.
Before you continue
Can you do these?
- Compare LP result with holding.
- Estimate fee offset.
- Understand what happens if one asset trends hard.
Related learning
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Impermanent loss happens when…