Impermanent Loss Explained: Formula, Example and Pool Fees
Lesson 4 of 10 · Intermediate
What is a liquidity pool (and what it is not)?
A liquidity pool in DeFi is a contract that holds two or more tokens so that others can trade against it. The people who supply those tokens are called liquidity providers (LPs), and in return they earn a share of the trading fees. Each LP’s share is represented by a token or NFT that, on exit, returns their portion of the pool’s balances at that moment.
A common ambiguity: in analytical styles such as ICT and smart money, a “liquidity pool” means a zone on a chart where stop orders have accumulated. That is an entirely separate concept. In this lesson we mean only the DeFi liquidity pool.
The key point: an LP deposits two tokens at a fixed value ratio (50/50 in simple pools), but on exit the composition of their assets may be completely different. The reason is the same arbitrage we saw in the AMM lesson.
What is impermanent loss and where does it come from?
When the price of one of the two tokens rises in the outside market, arbitrageurs buy that token from the pool (because it is cheaper there) until prices align. The result: the pool holds less of the token that became more valuable and more of the one that lagged. In effect, the LP automatically sells the winner and buys the loser.
Impermanent loss (IL) is the gap between the value of your share in the pool and what you would have had by simply holding the same two tokens in a wallet. For a 50/50 pool with the x*y=k formula, if r is the ratio of the new price to the starting price:
IL = 2√r ÷ (1 + r) − 1
| Price change of one token relative to the other | Impermanent loss versus holding |
| 1.5 times | about 2% |
| 2 times or half | about 5.7% |
| 3 times | about 13.4% |
| 4 times or one quarter | 20% |
| 5 times | about 25.5% |
Two points about this table: IL is not sensitive to the direction of the move (doubling and halving produce the same loss) and it grows quickly as the move gets larger.
A hypothetical example, step by step
Suppose that when ether is 2,000 dollars you deposit 1 ETH and 2,000 stablecoins (4,000 dollars in total) into a 50/50 pool. Then the price of ether in the market rises to 8,000 dollars (four times).
- If you had just held: 1 ETH worth 8,000 dollars + 2,000 stablecoins = 10,000 dollars.
- In the pool: arbitrage has changed your share’s composition to about 0.5 ETH and 4,000 stablecoins, which is about 8,000 dollars.
- The gap: about 2,000 dollars, or 20 percent less than holding, before counting fees.
Why “impermanent”? Because if the price returns to the starting point, the gap disappears. But if you exit at the new price, the loss is entirely permanent. The name is misleading; the loss is impermanent only while you have not exited and while price comes back, which is not guaranteed.
Fees against impermanent loss: the real evidence
An LP receives fees in return for this risk. The central question is: do the fees offset IL? The answer depends on trading volume, the fee rate, volatility and how long you stay, and no figure is guaranteed.
The empirical evidence is a warning. According to Cryptobriefing’s report on a 2021 study by Topaze Blue and Bancor of about 17,000 wallets on Uniswap v3, roughly half of LPs had negative returns versus simple holding after fees. In that sample, total IL was estimated at about 260 million dollars against about 199 million dollars in total fees. It is one study over a specific period and cannot be generalised with certainty, but it shows that “earning fees” is not the same as “making a profit”.
Concentrated liquidity: more fees, more risk
In concentrated-liquidity pools (such as Uniswap v3), the LP places capital only in a chosen price range. Inside the range, capital is used more efficiently and earns a larger share of fees. But:
- IL is amplified: the narrower the range, the faster a price move changes your share’s composition.
- Leaving the range: if price exits the range, your position becomes 100 percent the token that fell in value and earns no more fees.
- Active management: moving a range costs network fees each time and effectively locks in the loss.
Pools pairing two stablecoins have negligible IL as long as both stay pegged to the dollar. If one depegs, the pool quickly fills with the faulty token and LPs have in effect bought it. That is what was seen in the collapse chain of synthetic stablecoins in November 2025.
Common mistakes
- Confusing a DeFi liquidity pool with the ICT-style “liquidity pool”, a completely different concept on a chart.
- Believing impermanent loss is “temporary and unimportant”; if you exit at the new price it is permanent.
- Looking only at fee APR and not comparing the final value with simply holding the same two tokens.
- Choosing a very narrow range in concentrated liquidity for more fees, without understanding that leaving the range means converting fully into the weaker token.
- Assuming a two-stablecoin pool is risk-free; if one depegs, the pool fills with the faulty token.
What do volume and data say here?
For an LP, trading volume is the “income” and volatility is the “cost”. Read the data accordingly:
- Volume-to-TVL ratio: daily volume divided by TVL, multiplied by the fee rate, gives a rough fee yield. If much of the volume comes from arbitrage bots, that same volume is a sign of price movement and of IL as well.
- Historical volatility of the pair: the further apart two tokens drift, the larger the IL. Pairs whose price ratio is stable have less IL.
- Direction of flow in the pool: if the balance of one of the two tokens keeps growing, the market is selling it into the pool; LPs are accumulating that token.
- Do your own math: before depositing, run the IL formula for a few hypothetical price scenarios and compare it with your fee estimate.
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Frequently asked questions
What is a liquidity pool?
A DeFi smart contract that holds two or more tokens so traders can trade against it. Liquidity providers deposit the tokens and earn a share of trading fees. It differs from the ICT concept of a liquidity pool.
How is impermanent loss calculated?
For a simple 50/50 pool, if r is the ratio of the new price to the starting price, the loss versus holding is 2√r ÷ (1 + r) − 1. For example, a fourfold price move creates about 20 percent impermanent loss.
Do fees cover impermanent loss?
Sometimes yes and sometimes no. It depends on volume, fee rate, volatility and time in the pool. In a 2021 study by Topaze Blue and Bancor, roughly half of the Uniswap v3 LPs sampled trailed simple holding.
Education only, not a recommendation to buy or sell; we never give signals. Price examples are illustrative. Test any method on a demo account first, with strict risk management.