Impermanent loss in crypto: Understanding the real risk of providing liquidity

In a nutshell, the value of your tokens left in a liquidity pool will likely be lower than if you had just held those same tokens in your crypto wallet. This "loss" occurs when the token pair diverges in price due to how automated market makers (AMMs) calculate swap values. However, you'll also earn swap fees that offset your impermanent loss. Swap fees often cover the difference, leaving you with a net gain.

If you're new to providing liquidity in decentralized finance (DeFi), you've probably encountered the term impermanent loss (IL), accompanied by some confusing math. The good news is that IL is less complicated than it seems.

IL isn't the boogeyman it's often portrayed as; it is better described as an opportunity cost rather than a loss. In some ways, it's like renting out a house for ongoing income rather than selling it in pristine condition at the market peak. Renting leaves some wear and tear, but you're getting paid along the way.

In this guide, we'll discuss the math behind impermanent loss as well as ways to reduce your risk by using correlated assets. IL isn't a reason to avoid liquidity provision, but it's a key element to understand before you start. Let's begin with some basics.