What is impermanent loss?

Impermanent loss describes the shortfall of a liquidity position relative to holding its original token quantities when their relative prices change. The comparison matters: it is not simply a decline in the position’s dollar balance.

As traders move a pool’s balances toward a changed market price, the provider ends up with a different mix of assets. In a simple equal-value constant-product pool, the position can hold less of the token that appreciated. Fees can offset some or all of the shortfall, but that is a separate calculation.

Reference: Uniswap v2 — Understanding liquidity-provider returns ↗

Calculate a simple 50/50 pool example

Imagine depositing 1 unit of token A worth $100 and $100 of a hypothetical dollar-pegged token B. The starting value is $200. Ignore fees, rounding, gas, and peg changes, and assume a full-range constant-product position. Its initial reserve product is 1 × 100 = 100.

Now A’s external price doubles to $200 while B remains at $1. After price alignment, the position’s proportional reserves become about 0.7071 A and 141.42 B. Their combined value is about $282.84.

Holding the original 1 A and 100 B would instead be worth $300. The liquidity position gained $82.84 compared with its initial value, yet it is $17.16 behind holding. That $17.16 is about 5.72% of the $300 holding benchmark. A positive dollar return and impermanent loss can therefore occur at the same time.

What the formula does—and does not—measure

Here r is the ending relative price divided by the starting relative price. A halving gives the same percentage shortfall as a doubling in this idealized model. The calculation compares two strategies at the same ending prices.

It does not model swap fees, rewards, transaction costs, changes in the dollar peg, or losses caused by a contract exploit. It also does not describe every liquidity design. A concentrated position or an unequal-weight pool needs a calculation that matches its rules.

Why the word “impermanent” can mislead

In the simplified model, a return to the starting price ratio removes the modeled shortfall before fees and costs. The market is not obliged to return. Calling the effect impermanent does not make it harmless while you remain in the pool.

Withdrawing changes how you hold the assets, but waiting is not a guarantee of recovery. The position already has an opportunity-cost difference at the measurement time. Keep that distinction clear when evaluating a dashboard that highlights fee earnings but omits the holding benchmark.

Measure performance with a consistent baseline

Record the deposited quantities, entry prices, fees earned, rewards, and transaction costs. At the comparison time, value both the LP position and the original quantities using the same prices. This makes the comparison reproducible.

If you add or remove liquidity, track each change rather than applying the two-price shortcut to an entire changing position. More complicated activity needs a cash-flow-aware calculation. The simple example is useful for learning the mechanism, not for replacing an accurate position report.