🔄 How Impermanent Loss Works
Understand why price divergence causes losses for LPs
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0 / 5 completed⚙️ The Mechanics of Impermanent Loss
Understanding exactly how impermanent loss occurs requires looking at the constant product formula and how it forces rebalancing as prices change.
🎮 Interactive: Step-by-Step IL Demonstration
Walk Through Each Step
Step 1: Initial Deposit
You deposit 1 ETH + 2000 USDC when ETH = $2000
Why the AMM Rebalances
Maintaining the Constant
The formula x × y = k must hold true. When arbitrageurs trade to profit from price differences, they push your position toward the new equilibrium.
Automatic Profit Taking
When ETH pumps, the AMM automatically sells your ETH for USDC. You're forced to take profits, missing further upside.
Buying the Dip (Automatically)
When ETH dumps, the AMM buys more ETH with your USDC. You're averaging down, but catching a falling knife.
Key Insight
Impermanent loss is mathematically guaranteed by the constant product formula. It's not a bug—it's how AMMs work. The trade-off is earning trading fees in exchange for this rebalancing risk.
When price changes: √(P_new/P_old) = ratio of new balances
Example: 2x price → 0.707x ETH & 1.414x USDC
IL in Different Market Conditions
| Market | Price Action | IL Impact |
|---|---|---|
| Sideways | Minimal divergence | Low - fees likely profitable |
| Bull Market | Strong uptrend | High - miss gains vs holding |
| Bear Market | Strong downtrend | High - amplify losses vs holding |
| Volatile | Large swings | Very High - worst case scenario |