Impermanent Loss in Yield Farming: It’s Not What you Think

If you’re new to DeFi and yield farming, you may see this term thrown out there again and again. But what does it exactly mean? And how does the impermanent loss in yield farming work?

Impermanent loss is a recurring risk or drawback we see in yield farming and liquidity pool protocols. Some people either don’t understand what it is, or they think they do but are confusing it with something completely different. 

Today, we’ll explain what impermanent loss is and how it works, along with some steps you can take after you incur one and some ways to protect yourself against it.

What is an Impermanent Loss in Yield Farming?

In simple words, if you contribute liquidity in a liquidity pool protocol and the price of your cryptocurrency changes in any direction (whether it falls or rises) in the real world, you realize an impermanent loss. 

It’s impermanent because the price may restore to its initial position, and the loss may reverse.

Now, that’s a little too simplified. To understand how impermanent loss in yield farming works, you must know how liquidity pools and Automated Market Makers (AMM) work

You can only contribute pairs of tokens (cryptocurrencies) in a liquidity pool. The price of these tokens is determined by their ratio and is independent of external factors. 

So, if you put an ETH-USDT pair in a liquidity pool and the ETH prices rise by 10% in the real world, it would not affect the price of ETH in the liquidity pool. And that’s what impermanent loss really means. 

In other words, an impermanent loss is the lost opportunity cost of not keeping your cryptocurrency in your wallet where you may have realized a higher gain (return) than on a liquidity pool, which usually pays the liquidity provider with a percentage of the trading fees. 


Suppose you invest (contribute) in an asset pair – ETH and USDT, where ETH = $200 and USDT = $1 (or 1 ETH = 200 USDT).

Since the ratio of the pair should be 50/50, you contribute 1 ETH and 200 USDT, making your total contribution $400. 

The pool has a total of 10 ETH and 2000 USDT, which makes the total liquidity of the pool $20,000 (20×2000), where you hold 10% of the shares. 

Now, for some reason, the price of ETH in the real-world market goes from $200 to $400. But since the price in a liquidity pool is unaffected by external factors, ETH is selling at lower than its actual price in this liquidity pool (this gives rise to an arbitrage opportunity, but that’s a separate topic).

This is where you incur an impermanent loss. You may think this is confusing, but to be fair, this is a pretty watered-down and simplified example. In the real world, calculating all of this can get “pulling your hair out” difficult, which brings us to…

How to Calculate Impermanent Loss?

Calculating impermanent loss is difficult. To stop you from experiencing the mathematical horror it will cause, here’s a calculator that can automatically calculate any impermanent loss in yield farming. 

What to Do After Incurring an Impermanent Loss?

After incurring an impermanent loss, you have two options – 

a) You can either incur a permanent loss and exit the pool before the price drifts too far and you incur a greater loss. 

b) You can risk it and wait till the price restores to its initial position. 

Both have their own downsides. If you exit the market, you may save yourself from more potential impermanent loss, but you’ll incur a permanent loss. If you wait, you may not lose anything, but at the same time, you risk losing more than you already have. 

There is no right answer here. Which approach you should take will vary from case to case, depending on the market trends, the asset pair, how much loss you incurred and numerous other factors. 

How to Avoid Impermanent Loss in Yield Farming?

Yield farming and DeFi are pretty tricky. Add the volatile nature of cryptocurrency on top of it, and you get yourself in a situation where it’s hard to tell what’s the right move. Though it’s impossible to avoid impermanent loss totally, there are ways you can reduce the possibility of it. 

  • Pair your cryptocurrencies with stablecoins. Though it doesn’t guarantee anything, pairing ordinary cryptocurrencies with stablecoins is pretty standard practice in liquidity pools and yield farming. 
  • Don’t invest in volatile pairs. Take your time and do your research. Check out different pairs and the risk associated with them in advance. The more prepared you’re, the lesser the possibility of an impermanent loss. 
  • Avoid adding liquidity if the market is highly bullish because when the market is bullish, you’ll invariably incur impermanent losses. 
  • Don’t add all your holdings to liquidity pools. Instead, only contribute half. This way, you’ll cut your losses by half. The downside – you’ll also cut your rewards by half. 
  • Look into impermanent loss protection

These are some ways you can avoid or try avoiding impermanent loss in yield farming. Other than that, realize that if you’re new to yield farming and liquidity pools, you’ll inevitably lose money. It’s part of the learning curve. So, take the falls, learn the lessons, come back here to revise and go in stronger.