What is Impermanent Loss?

Impermanent Loss is a temporary reduction in asset value experienced by Liquidity Providers (LPs) in Automated Market Maker (AMM) pools due to price fluctuations. Under the Constant Product Market Maker model, if an LP withdraws liquidity while asset prices have diverged, the value of their withdrawn assets may be lower than if they had simply held the tokens. This difference is called impermanent loss. Importantly, this loss is only realized upon withdrawal — if the asset price ratio returns to its original level, the loss disappears.

Example of Impermanent Loss

1. Assuming that currently there are 1,000 CET and 500 USDT in the liquidity pool, the constant product is 1,000 * 500 = 500,000. The liquidity Provider(LP) Adam holds 10% of the assets in the CET/USDT pool, that is, 100 CET and 50 USDT. At this time, 1 CET = 0.5 USDT.

2. Suppose that after a while, the CET price rises, and the amount of the pool tokens has changed to 500 CET and 1,000 USDT. The constant product 500 * 1,000 = 500,000 remains the same, but at this time, 1 CET = 2 USDT. LP Adam's holdings in the pool also change accordingly, becoming 50 CET and 100 USDT.

3. Assuming that LP Adam removes liquidity when the pool contains 500 CET and 1,000 USDT, since he has a 10% share, in total, he can remove 50 CET and 100 USDT. After removing liquidity, the value of his assets is 50 * 2 + 100 = 200 USDT.

4. At the time of adding liquidity, Adam owned 100 CET and 50 USDT. If he simply held the tokens and did not invest in the liquidity pool, the total asset value would be 100 * 2 + 50 = 250 USDT. However, after removing liquidity, he only gets 200 USDT. The difference in value between adding liquidity and simply holding the assets is the impermanent loss. In Adam‘s case, the loss is 50 USDT.

Note: To simplify the calculation, the trading fee is not considered in the above example.

Impermanent Loss Estimation

Here’s a chart of estimated Impermanent Loss for your reference:

How to Avoid Impermanent Loss?