Yield farming has become one of the most popular activities in decentralised finance. It gives investors the chance to earn passive income by providing liquidity to protocols that enable trading, lending, and other on-chain services. However, one of the least understood risks is impermanent loss. Many farmers discover only after withdrawing funds that they would have been better off simply holding their tokens.
Impermanent loss is not a minor issue. It directly affects your net returns and can quietly erode the appeal of high APY pools. In this guide, we will explain what impermanent loss is, why it happens, how much it can cost you, and what strategies you can use to minimise its impact while still benefiting from yield farming.
What Is Impermanent Loss?
Impermanent loss happens when the price of tokens in a liquidity pool changes relative to each other. Automated market makers (AMMs) such as Uniswap, PancakeSwap, and SushiSwap require liquidity providers to deposit equal values of two tokens, often in a 50:50 ratio.
When one token rises or falls in value compared to the other, arbitrage traders rebalance the pool. This benefits traders by keeping prices in line with the wider market, but liquidity providers end up with more of the underperforming token and less of the appreciating one.
The loss is called impermanent because it disappears if prices return to the original ratio. But if you withdraw while prices remain divergent, the loss becomes permanent compared to simply holding your tokens.
A Simple Example
Suppose you add $1,000 of liquidity to an ETH/USDC pool, split into $500 in ETH (0.5 ETH at $1,000 each) and $500 in USDC.
- If ETH doubles to $2,000, the pool rebalances. You withdraw with 0.35 ETH and more USDC, worth around $1,414.
- If you had simply held your 0.5 ETH and $500 USDC, your portfolio would now be worth $1,500.
- The $86 difference is impermanent loss.
You still made money in dollar terms, but less than if you had held. That gap is the invisible cost of yield farming.
How Much Does Impermanent Loss Cost?
The severity of impermanent loss depends on how far the token prices move apart. The table below shows approximate impermanent loss compared to holding for different price changes:
| Price Change of One Asset | Impermanent Loss (%) |
|---|---|
| +25% | 0.6% |
| +50% | 2.0% |
| +100% (2x) | 5.7% |
| +200% (3x) | 13.4% |
| +400% (5x) | 25.5% |
| +900% (10x) | 42.3% |
Even modest moves create measurable losses. The larger the divergence, the bigger the hidden cost. This is why impermanent loss matters so much for pairs with volatile assets.
Why Impermanent Loss Matters
Impermanent loss is easy to overlook because it is not visible in your wallet balance. You only see the effect when comparing your liquidity position with a simple hold strategy.
- For long-term holders: If you want to accumulate ETH or BTC, liquidity provision may reduce your upside because you sell appreciating tokens automatically.
- For stablecoin farmers: Small divergences add up, especially in pools with low fees.
- For volatile pairs: Impermanent loss can cancel out incentive rewards, leaving you worse off despite a high APY.
Yield farming is attractive, but ignoring impermanent loss is like ignoring trading fees. It quietly eats into your returns.
Strategies to Avoid or Reduce Impermanent Loss
Strategy 1: Stick to Correlated or Stable Assets
One of the most effective ways to mitigate impermanent loss is by providing liquidity to pools composed of assets that move in sync or have minimal price volatility relative to each other. Stablecoin pairs such as USDC/DAI or USDT/BUSD are prime examples. Because their prices remain close to 1:1, the risk of significant divergence is low.
Another category includes synthetic tokens and wrapped versions of the same asset, such as ETH/stETH or BTC/wBTC. These tokens are often pegged or linked through underlying mechanisms, reducing the risk of divergence and therefore reducing exposure to impermanent loss.
While these pools often offer lower trading fees or yield incentives compared to more volatile pairs, they provide more predictable performance. For users who prioritise capital preservation over high-risk, high-reward farming, these stable or correlated pairs are ideal.
Strategy 2: Choose Protocols That Offer Impermanent Loss Protection
A growing number of DeFi protocols have introduced mechanisms to reduce or offset impermanent loss. Bancor was the first to offer a protocol-level solution with its single-sided staking and compensation system. Users can deposit one asset, and if they remain in the pool for a minimum duration, the protocol gradually covers any impermanent loss.
Thorchain offers a similar approach by subsidising LPs through block rewards, while other emerging protocols like Bancor 3 are building on these models. Some even combine rebalancing incentives with insurance-like coverage to shield LPs from volatility.
These systems are still evolving and come with their own trade-offs. Such as protocol-specific risks, lock-up periods, or token exposure. But they represent important innovations in DeFi‘s risk mitigation toolkit. Users interested in minimising loss while staying active in volatile pools should explore these options carefully.
Strategy 3: Farm Protocol Incentives to Offset Impermanent Loss
Many yield farms offer token rewards to compensate for risks taken by liquidity providers. These rewards are usually distributed in the form of governance or utility tokens and are added on top of trading fees earned from AMM activity.
If the incentive rewards are high enough, they can more than make up for any impermanent loss incurred. For instance, if you provide liquidity to a volatile ETH/ALT pair and earn 60% APY in token incentives, you may still end the year ahead even if you suffer 10% in impermanent loss due to price divergence.
This strategy does require careful evaluation. Protocol tokens may be volatile, and APYs can drop as more liquidity enters the pool. Ensure that you understand the risks of the reward token’s price collapsing or becoming illiquid.
It’s also important to consider whether the rewards are vested, locked, or immediately claimable.
Strategy 4: Use Concentrated Liquidity and Custom AMM Models
Newer AMM designs offer more flexibility for liquidity providers. Platforms such as Uniswap v3, Algebra, and Arrakis allow you to concentrate your liquidity within a specific price range. Instead of providing capital across an entire curve, you can deploy it in a narrow band where most trading occurs.
This concentrated approach increases fee efficiency and reduces exposure to unwanted price movements outside your range. If the asset stays within the selected band, you earn more fees with less capital and potentially less impermanent loss. However, if prices move outside your range, your position becomes inactive, and you stop earning.
Protocols like Balancer allow asymmetric pools, such as 80:20 or 95:5 weightings, which let you stay more exposed to one token while still earning from the pool. These are particularly useful for users with a long bias on one asset but who want some additional yield.
Strategy 5: Time Your Entries and Monitor Volatility
Impermanent loss is more likely to occur during periods of high price volatility. If you enter a pool during relative market stability, the chance of extreme divergence is lower. Monitor token correlations and look for moments when both assets are trading within a predictable range.
It also helps to time your exits. If you notice that the price divergence is increasing, but the trend looks temporary, it may make sense to delay withdrawal until the prices converge again. Remember, the loss is not locked in unless you exit while divergence is present.
Using tools like DeFi Llama, APY.vision, and Token Terminal can help you track pool metrics and monitor your portfolio’s performance. You can also use backtesting tools to understand historical behaviour and estimate how much impermanent loss similar positions would have experienced over time.
Comparing Impermanent Loss With Other DeFi Risks
DeFi has multiple risks, but impermanent loss is unique because it is structural.
- Smart contract risk: Bugs or hacks.
- Market risk: Asset prices falling outright.
- Liquidity risk: Pools drying up or exit costs rising.
- Impermanent loss: Built into AMM mechanics.
You cannot audit or insure impermanent loss away. It is part of the design and must be managed with strategy.
Best Practices for Managing Impermanent Loss
- Start small with stable pairs before trying volatile ones.
- Diversify across different pools and blockchains.
- Choose audited protocols with strong reputations.
- Regularly compare your LP position to a hold benchmark.
- Keep manual overrides even if using automation.
- Reassess your strategy as incentives and conditions change.
The Future of Impermanent Loss Mitigation
Impermanent loss has driven innovation in DeFi and developers are experimenting.
- Insurance-style protection that reimburses LPs.
- Dynamic AMMs that rebalance automatically.
- Cross-chain aggregators that optimise liquidity globally.
- Hybrid models combining concentrated liquidity and subsidies.
As DeFi matures, impermanent loss may become less of a burden, opening liquidity provision to more mainstream investors.
Final Thought
Yield farming offers exciting rewards, but impermanent loss is the hidden cost every investor must understand. It is not about eliminating the risk, since that is impossible, but about managing it intelligently.
Whether you choose stablecoin pools, IL-protected protocols, concentrated liquidity, or incentive-driven strategies, the key is to measure risk against reward. By planning ahead and monitoring carefully, you can continue to farm yield while protecting yourself from one of DeFiCrypto & Defi’s most persistent challenges.
