Impermanent Loss Explained - SmartViewAI Blog

Where it comes from

An automated market maker pool holds two assets and prices them by a formula — commonly that the product of the two balances stays constant. Traders swap against the pool, and the pool's ratio shifts as they do.

When the external price of one asset moves, arbitrageurs trade against the pool until its price matches the market. That rebalancing is profitable for them, and the cost is borne by liquidity providers. Impermanent loss is that cost.

What it means in practice

You end up holding more of whichever asset fell and less of whichever rose. The pool automatically sold the winner into the rise and bought the loser into the fall.

Price change of one asset	Loss vs simply holding
1.25x	~0.6%
1.5x	~2.0%
2x	~5.7%
3x	~13.4%
5x	~25.5%

These figures are the standard result for a two-asset constant-product pool and are symmetric — a halving produces the same loss as a doubling.

Why it is called "impermanent"

If the price ratio returns to where it started, the divergence disappears. The name reflects that it is unrealised while you remain in the pool and prices may revert.

The name is also misleading, and worth being blunt about: the moment you withdraw, the loss is entirely permanent. Many people read "impermanent" as "temporary" and assume it resolves itself. It resolves only if the price ratio comes back.

Fees are the other side

Liquidity providers earn a share of trading fees. The position is profitable when fees earned exceed impermanent loss over the period held.

That favours high-volume pools with assets that move together. It disfavours pools where one asset can move dramatically against the other — which is precisely where the advertised yield is usually highest.

Which pools carry how much risk

Stablecoin pairs — minimal divergence, so minimal impermanent loss, and correspondingly modest fees.
Correlated pairs — an asset and its staked derivative, for instance. Moderate risk.
Major pairs — real exposure during trending markets.
Volatile or new tokens — the highest advertised yields and by far the highest risk. A token that collapses leaves you holding almost entirely that token.

Judging an advertised APR

A headline yield does not account for impermanent loss, and cannot, because it depends on price movement that has not happened yet. Before providing liquidity, ask what price divergence would erase the fees, and whether that divergence is plausible over your holding period.

For Indian users there is an additional consideration that is easy to miss: entering and exiting a pool involves token transfers that may be taxable VDA transfers, and the resulting record-keeping is substantial. Factor that in before treating a yield figure as a return.

Concentrated liquidity changes the maths

Newer automated market makers let providers concentrate liquidity within a chosen price range rather than spreading it across all prices. Inside the range, capital earns far more fees; outside it, the position earns nothing and sits entirely in one asset.

This amplifies both sides. Fee income rises substantially, and so does impermanent loss when price leaves the range — because the position has effectively been fully converted into the weaker asset at every step on the way out.

Concentrated positions therefore require active management. A range set and forgotten will, in a trending market, end up entirely on the wrong side of it. This is a materially different activity from passive liquidity provision, and it is frequently presented as though it were the same thing with better yields.

Single-sided and protected pools

Some protocols offer single-sided deposits or mechanisms intended to offset divergence. These do not remove the underlying economics — the cost is borne somewhere — but they can transfer it, for instance to the protocol's treasury or to another class of participant.

When evaluating such a product, the question worth asking is who is absorbing the divergence and whether they can continue doing so under stress. Mechanisms that work in calm conditions and fail in volatile ones are common, and the failures cluster exactly when they matter.

A checklist before providing liquidity

What price divergence would erase the fees I expect to earn?
How likely is that divergence over my intended holding period?
What are the two assets' historical correlation — do they move together?
Has the contract been audited, and how much value has it held for how long?
What does exiting cost in gas and, in India, in tax and record-keeping?

If the honest answer to the first question is "a move smaller than this pair routinely makes", the yield is not compensation for risk — it is an advance against a loss that has not yet been recognised.