Impermanent Loss in Crypto Explained: How It Works and How to Avoid It
“Even though the coin price increased, I ended up losing money after joining DeFi” is a statement you may have heard. Usually, that’s not because they picked the wrong coin, but rather because they suffered a brief loss. This can be especially confusing for people who are unfamiliar with liquidity pools.
This article will explain impermanent loss in plain, understandable terms. In order to prepare you for DeFi, you will learn what impermanent loss is, why it happens, how to calculate it, real-world examples, and how to prevent it.
What Is Impermanent Loss?
A situation known as “permanent loss” occurs when the value of the cryptocurrency assets you own in a liquidity pool drops relative to holding them in a standard wallet without engaging in any trading. This is limited to DeFi applications that make use of liquidity pools.
A liquidity pool is a collection of two different coin types that are used for trading without the use of middlemen like banks or brokers. When you deposit coins into the pool, you are called a liquidity provider and will receive a reward. However, because coin prices can fluctuate, the value of your assets in the pool can decrease compared to if you simply held them; this is called impermanent loss.
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How Does Impermanent Loss Work?
Impermanent loss occurs because liquidity pools must always maintain a balance between the two coins, usually 50%:50%. If the price of one coin rises or falls, the system automatically adjusts the number of coins in the pool.
When you deposit coins into a pool, you receive a special token called an LP token. This LP token represents your share of the pool and is used when you want to withdraw funds.
Problems arise when the coin price fluctuates significantly from the initial price. The system automatically exchanges some of your coins for other coins to maintain balance. As a result, when you withdraw funds, the value may be lower than if you had simply kept the coins in your wallet.
How to Calculate Impermanent Loss
To calculate impermanent loss, you need to compare two values: first, the current value of your assets in the liquidity pool, and second, the value of your assets if they had been held in your wallet without joining the pool. The initial value when you first deposited your assets into the pool serves as the primary benchmark for this comparison.
The simple formula is:
Impermanent Loss = (Pool Value / Wallet Value – 1) × 100%
The result of this calculation shows the percentage of value “lost” because you chose to join the liquidity pool instead of simply holding your assets.
For example, if you deposit 1 ETH and 1,000 DAI worth a total of $2,000, and then the price of ETH doubles, the pool system will automatically adjust the amount of ETH and DAI. If the value of your assets in the pool is $2,814, while if they were held in your wallet, they would be $3,000, then your impermanent loss is approximately 6.2%.
Please note that this calculation does not include rewards from the liquidity pool, so for more accurate results, add the reward value to your current total assets.
Example of Impermanent Loss
For example, Mei Lin deposits $100 worth of ETH and $100 worth of DAI into a liquidity pool. Her total contribution is $200, and she receives LP tokens that represent 20% of the total pool’s liquidity at that time.
If the price of ETH later doubles, the system will automatically rebalance the amounts of ETH and DAI inside the pool to maintain its ratio. When Mei Lin decides to withdraw her funds, the total value she receives might be around $2,814.
If Mei Lin had simply kept her ETH and DAI in her wallet instead of depositing them into the pool, their combined value would have been $3,000. The difference between these two outcomes is called impermanent loss, which in this example is approximately 6.2%.
How to Avoid Impermanent Loss in Liquidity Pools
Liquidity pools naturally carry the risk of impermanent loss, but this risk can be reduced. You can minimize losses and still make money with the appropriate approach. Here are a few doable strategies to lessen the effects of temporary loss.
Spread Out Your Liquidity Pools
Don’t put all your assets in a single liquidity pool. By spreading your funds across several different pools, you can reduce the risk if one pool experiences extreme price movements. This strategy is similar to not putting all your eggs in one basket, so if one falls, the others are still safe.
Adopt Dynamic Range Management
Some DeFi platforms allow you to define specific price ranges for your liquidity. This is called dynamic range management. This way, your liquidity is only active within a specific price range, reducing the risk of losses due to excessive price fluctuations.
Utilize Correlated Pair Pools or Stablecoins
Liquidity pools containing stablecoins (such as USDT and USDC) or coin pairs with similar price fluctuations (e.g., ETH and stETH) typically have a much lower risk of impermanent loss. Because the prices of both assets tend to be stable or in the same direction, the system doesn’t need to frequently exchange coins, thus preserving the value of your assets.
Track Positions with DeFi Resources
To keep an eye on your positions, use a portfolio tracking app or a DeFi dashboard. You’ll be able to determine when to increase, decrease, or remove assets before losses become substantial by keeping an eye on prices, pool ratios, and fees.
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Tax Implications for Impermanent Loss
Tax regulations for DeFi activities, including liquidity pools, vary by country. However, impermanent losses themselves are usually not immediately taxable. Most tax authorities do not tax unrealized gains or losses, meaning those that occur before you withdraw assets from the pool.
However, if you withdraw funds from a liquidity pool and the amount is less due to impermanent losses, this will affect the overall profit or loss calculation. This means the impact will only be felt when you actually exit the pool or exchange the assets.
Typically taxable events in DeFi include: exchanging assets, entering or exiting a liquidity pool, and receiving or exchanging LP tokens or reward tokens. Because crypto tax regulations are quite complex, it’s recommended to consult a tax advisor who understands crypto and use a portfolio tracking tool to keep your tax records organized and compliant.
Impermanent Loss Protection
Liquidity providers are shielded from losses resulting from impermanent losses by insurance known as Impermanent Loss Protection (ILP). Depending on its policy, the platform may reimburse all or part of the lost value in the event of a loss.
Typically, ILP only applies if you hold tokens in a specific farm for a certain period of time. This means you can’t immediately withdraw funds if you want full protection.
It’s important to note that not all platforms offer this feature. Furthermore, there are usually specific requirements, such as locking tokens for a certain period of time, for the protection to be active and effective.
Conclusion
The risk that occurs when you keep cryptocurrency in a liquidity pool and its value changes is known as impermanent loss. Your assets might be worth less than if you just kept them in a wallet.
Nonetheless, you can still make money and reduce risk in the DeFi world by comprehending how it operates, calculating it, and putting strategies like selecting the appropriate pool, spreading your risk, and utilizing DeFi tools into practice.
Kamila Putri
I am an SEO content writer who focuses on crafting clear, informative, and engaging content about financial technology, artificial intelligence, and trading innovation. My role involves transforming complex fintech concepts into accessible narratives that highlight how technology drives smarter trading and better business performance. Through research-driven writing and close collaboration with our expert teams, I aim to communicate Snap Innovations’ vision of empowering clients with advanced AI tools, intelligent trading systems, and tailored technology solutions that redefine efficiency and competitiveness in the global financial landscape.