Understanding Impermanent Loss in DeFi with Real Examples

Imagine putting $1,000 worth of ETH and $1,000 worth of USDC into a liquidity pool on a decentralized exchange. A week later, ETH crashes 40%. You check your position and see you now have less than $2,000 total-even though you didn’t sell anything. That’s impermanent loss. It’s not a hack. It’s not a scam. It’s math.

Most people think if you hold crypto, you just wait for the price to go up. But when you provide liquidity to a DeFi pool, you’re doing something completely different. You’re not just holding-you’re trading. And that trade has a hidden cost.

What Exactly Is Impermanent Loss?

Impermanent loss happens when the price of two assets in a liquidity pool changes relative to each other. The more they move apart, the bigger the loss. But here’s the twist: if the prices return to their original ratio, the loss disappears. That’s why it’s called impermanent.

It’s not a loss on paper. It’s a loss compared to what you would’ve had if you just held the tokens in your wallet. Think of it like this: you planted seeds in a garden. The soil shifts. Your plants grow crooked. If the ground settles back, they straighten out. But if it doesn’t, you end up with less than you started with-even though you never pulled the plants out.

How Does It Happen? The Math Behind AMMs

Decentralized exchanges like Uniswap and SushiSwap don’t use order books. Instead, they use something called an Automated Market Maker (AMM). At its core, it follows a simple rule: x × y = k.

Let’s say you add 1 ETH and 2,000 USDC to a pool. That’s a 50:50 value ratio. At the time, ETH is $2,000. So x = 1 ETH, y = 2,000 USDC. Multiply them: 1 × 2,000 = 2,000. That’s your constant k.

Now ETH drops to $1,000. Outside the pool, traders see ETH is cheaper. They buy ETH from the pool using USDC. Why? Because the pool still thinks ETH is worth $2,000. They’re getting a bargain.

As they buy, the pool’s ETH supply drops. USDC rises. The ratio shifts. The pool automatically rebalances to match the market price. So now, instead of 1 ETH and 2,000 USDC, you might have 0.7 ETH and 2,800 USDC. Total value? $1,000 × 0.7 + $2,800 = $3,500. Wait-that’s more than $2,000. So where’s the loss?

Here’s the catch: if you had just held your original 1 ETH and 2,000 USDC, you’d now have $1,000 + $2,000 = $3,000. But because the pool rebalanced, you have $3,500. So you’re ahead? Not quite.

You’re ahead because you got more USDC. But you gave up ETH. If ETH rebounds to $2,000, your pool position goes back to 1 ETH and 2,000 USDC. But if ETH stays at $1,000, you’re better off in the pool. So why is it called a loss?

Because you didn’t just hold-you traded. The loss is in the opportunity cost. You could’ve held 1 ETH at $2,000. Now you only have 0.7 ETH. Even though your total is higher, you’re missing out on the upside of ETH going back up. That’s the real cost.

Real Example: ETH vs. USDC

Let’s say you start with:

• 1 ETH ($2,000)
• 2,000 USDC ($2,000)

Total: $4,000

ETH drops to $1,200. The pool rebalances. You now have:

• 0.816 ETH
• 1,959 USDC

Your total value: $1,200 × 0.816 + $1,959 = $2,938

If you’d held instead: $1,200 + $2,000 = $3,200

Your loss? $3,200 - $2,938 = $262. That’s a 8.2% impermanent loss.

Now, ETH drops to $800.

• You have: 0.707 ETH, 2,121 USDC
• Your total: $800 × 0.707 + $2,121 = $2,687
• Held: $800 + $2,000 = $2,800
• Loss: $113 → 4% loss? Wait, no.

Actually, the loss is now $113, but as a percentage of your original $4,000? That’s 2.8%. But if you look at the ratio change, it’s actually worse. The math gets exponential. At a 50% drop in ETH price, your impermanent loss jumps to about 13.4%. At a 70% drop? It’s over 25%.

It’s not linear. It’s curved. And it hits harder the farther prices move.

Stablecoin Pairs: The Safe Bet

Not all pairs are equal. USDC/USDT? Almost no impermanent loss. Why? Because their prices don’t move. They’re both pegged to $1. Even if one dips to $0.999, it snaps back. The rebalancing is tiny.

That’s why most beginners start with stablecoin pairs. They earn trading fees-often 0.01% to 0.05% per trade-with almost no risk of loss. If a pool has high volume, you can make 5-10% APR just sitting there.

Compare that to ETH/DAI. If ETH swings 30% in a week, you could lose 10% even if you made 2% in fees. Net loss. That’s why experienced users avoid volatile pairs unless they’re betting on price convergence.

When Impermanent Loss Turns Into Profit

Here’s the flip side: fees can cover the loss.

Let’s say you put $10,000 into an ETH/USDC pool during a bull run. ETH surges from $2,000 to $4,000. You take a 22% impermanent loss. But over six months, the pool generates $2,500 in trading fees. You still come out ahead.

That’s the game. You’re not trying to beat the market. You’re trying to earn while the market moves. The fees are your safety net.

Some users stay in volatile pools for years. They ride the ups and downs. When ETH drops, they lose. When it rises, they lose more. But over time, the fees add up. By the third cycle, they’ve earned more than they ever lost.

How to Protect Yourself

You can’t avoid impermanent loss. But you can manage it.

1. Start with stablecoins. USDC/USDT, DAI/USDC. Low risk, steady income.
2. Avoid highly volatile pairs. ETH/SHIB? BTC/PEPE? Bad idea unless you know exactly what you’re doing.
3. Use Uniswap V3. It lets you set price ranges. Put your liquidity only between $1,800 and $2,200 for ETH. If ETH stays in that range, you earn more fees. If it leaves, your position stops trading-but you avoid the worst of the loss.
4. Use a calculator. There are free tools online. Plug in your pair and price change. See the loss before you deposit.
5. Track fees. If your fees don’t cover 50% of the expected loss over 3 months, get out.

Many beginners lose money because they treat liquidity pools like savings accounts. They’re not. They’re active trading positions. You’re the market maker. And market makers get hurt when prices swing wildly.

Why This Matters for DeFi

Over $18 billion is locked in DeFi liquidity pools as of late 2024. That’s not small change. But many users don’t understand how these pools work. They hear “earn 15% APY” and jump in. Then they panic when their balance drops.

Impermanent loss isn’t a bug. It’s a feature. It’s how AMMs keep prices aligned with the real market. Without it, the whole system would break.

The real risk isn’t the loss. It’s not knowing it’s coming.

Those who succeed in DeFi aren’t the ones who predict price movements. They’re the ones who understand the math, accept the trade-offs, and build positions that survive multiple cycles.

Final Thought: It’s Not Loss-It’s Opportunity Cost

Call it what you want. Impermanent loss. Opportunity cost. The price of being a market maker.

If you want to earn from crypto without selling, liquidity pools are one of the few ways to do it. But you’re not passive. You’re participating. And participation has rules.

Know the math. Choose your pairs wisely. Track your fees. And never assume your balance going down means you made a mistake. Sometimes, you’re just playing a different game.