Impermanent loss (IL), also known as divergence loss, is a key risk for liquidity providers (LPs) in traditional constant-product liquidity pools. It occurs when the relative prices of pooled tokens change, reducing the value of an LP’s deposit compared to simply holding the tokens outside the pool. Managing IL is essential for LPs to maximize returns.
How Impermanent Loss Occurs
When you provide liquidity to an A/B pool:
- If Token A’s value rises against Token B, the pool rebalances: you receive more of Token B and less of Token A.
- If the combined value of your pooled tokens becomes lower than holding the original tokens separately, you incur impermanent loss.
This loss is "impermanent" because it’s only realized upon withdrawing liquidity. Higher market volatility worsens IL, as price divergence increases.
Examples of Impermanent Loss
Example 1: Moderate Price Increase
- Deposit: $100 BONK + $100 SOL.
Scenario: BONK appreciates 1.5x (150%), SOL remains stable.
- Holding Tokens: $150 BONK + $100 SOL = $250 total.
- Pooled Value: $245 → **$5 IL** ($250 - $245).
Example 2: Significant Price Surge
- Deposit: $100 BONK + $100 SOL.
Scenario: BONK surges 4x (400%), SOL unchanged.
- Holding Tokens: $400 BONK + $100 SOL = $500 total.
- Pooled Value: $200 BONK + $200 SOL = $400 → $100 IL.
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Key Insight: Greater price divergence = higher IL. Losses reverse if prices return to the original ratio but become permanent if they don’t.
Calculating Impermanent Loss
A precise formula determines IL based on price changes between pooled assets. For DLMM pools, factors like bin distribution and fee income affect calculations.
Tools for LP Management
- Google Sheets Calculator: Estimate IL for positions with 69 bins (adjust for custom liquidity distributions).
- 24hr Fee/TVL Impact: Actual earnings may offset IL.
FAQs on Impermanent Loss
1. Can impermanent loss exceed my initial deposit?
No, IL reflects reduced value compared to holding tokens—it doesn’t erase your principal.
2. Do fees compensate for impermanent loss?
Yes, if trading fees/yield (e.g., farming) outweigh IL, net gains are possible.
3. How can I reduce IL risk?
- Choose stable asset pairs (e.g., ETH/USDC).
- Use concentrated liquidity protocols.
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4. Is impermanent loss tax-deductible?
Tax laws vary; consult a professional. Some jurisdictions treat IL as a capital loss.
Key Takeaways
- Monitor Price Trends: Anticipate volatility to adjust LP positions.
- Diversify Pools: Spread liquidity across multiple pairs to mitigate risk.