Impermanent loss

Why do you lose?

An automated market makerAutomated market maker (AMM)A smart contract that prices tokens on a decentralised exchange with a fixed formula, based on how much of each token sits in the pool. prices the tokens based on the ratio between them in the pool. When the price of one token rises on other markets, traders buy it cheaply from the pool until the price evens out. The pool is left with less of the token that went up and more of the other one. In effect, you keep selling whatever rises and buying whatever falls.

An example

Say you put 10 tokens and 1,000 USDC into a pool when one token costs 100 USDC. Your deposit is worth 2,000 USDC. Then the token's price quadruples to 400 USDC.

• In the pool, your share is now 5 tokens and 2,000 USDC, worth 4,000 USDC in total.
• Had you held the tokens, you would have 10 tokens and 1,000 USDC, worth 5,000 USDC in total.

The difference is 1,000 USDC, or 20%. The same happens if the price falls to a quarter. If the price doubles, the difference is about 5.7%. The further the prices drift apart, the bigger the loss. The example leaves out trading fees, which can make up for some or all of the loss, but there is no guarantee.

When does the loss become permanent?

The loss is called impermanent because it only exists on paper while your money is in the pool, and it disappears if the prices return to their original ratio. If you withdraw before that happens, however, the loss becomes permanent. Prices seldom end up exactly back where they started, so in practice the loss often does become permanent.