Liquidity Provision & Impermanent Loss
Every DEX swap has a counterparty: the liquidity providers. Becoming one means earning trading fees around the clock — and taking on a risk most beginners underestimate. This guide explains how pools pay you, what impermanent loss really costs, and how to judge whether a pool is worth it.
How a Liquidity Pool Works
You deposit two tokens of equal value — say $500 of ETH and $500 of USDC — and receive LP tokens representing your share of the pool. Every trader who swaps against the pool pays a fee (typically 0.01 %–0.3 %), distributed to providers in proportion to their share.
The catch: the pool constantly rebalances your holdings. Every trade changes the mix, and arbitrage keeps pool prices in line with the wider market — which means you always accumulate more of the token that is falling and less of the one that is rising.
Impermanent Loss, With Real Numbers
Take that $1,000 deposit ($500 ETH + $500 USDC) and let ETH double. Had you simply held both assets, you would have $1,500. In the pool, rebalancing leaves you with about $1,414. The $86 gap — about 5.7 % — is impermanent loss: the amount by which providing liquidity underperformed just holding.
It is called "impermanent" because it shrinks to zero if prices return to where you started — but it becomes very permanent the moment you withdraw. And note the symmetry: the loss depends only on how far the price ratio moves, in either direction.
1.25x or 0.8x
Loss vs holding: ≈ 0.6 %
1.5x or 0.67x
Loss vs holding: ≈ 2.0 %
2x or 0.5x
Loss vs holding: ≈ 5.7 %
3x or 0.33x
Loss vs holding: ≈ 13.4 %
4x or 0.25x
Loss vs holding: ≈ 20.0 %
5x or 0.2x
Loss vs holding: ≈ 25.5 %
Fees vs Loss: When LPing Wins
Liquidity provision is profitable when fees plus incentives outrun impermanent loss. That equation looks very different by pair type. Stablecoin pairs (USDC/USDT) have near-zero IL and small but steady fees. Correlated pairs (ETH/stETH) behave similarly. Volatile pairs (ETH/newtoken) can show spectacular fee APRs — and IL that eats them whole.
Concentrated liquidity (Uniswap v3 and successors) lets you provide within a price range, multiplying your fee earnings — and your impermanent loss — for the same capital. It is a professional's tool: ranges need monitoring and rebalancing, and a position that drifts out of range earns nothing.
Before You Provide Liquidity
Five checks separate deliberate LPs from liquidity that merely feeds arbitrage bots.
Start correlated or stable
Your first pool should be a stablecoin pair or a tightly correlated pair like ETH/stETH. Learn the mechanics where impermanent loss is measured in fractions of a percent, not double digits.
Compare fee APR against likely IL
Estimate how far the pair could realistically move over your holding period and read the loss off the table above — then ask whether the pool's actual fee APR covers it with margin. Our calculator does the arithmetic for you.
Check volume, not just TVL
Fees come from trading volume, not from pool size. A pool with high TVL and low volume splits few fees among many providers. Look at the volume-to-TVL ratio on DefiLlama or the DEX's own analytics.
Discount incentive APRs
Emissions paid in a project's own token can collapse in price long before you harvest them. Treat advertised incentive APY as a bonus, not the base case — the fee APR is the real yield.
Size it as a strategy
LP positions need attention: peg checks on stable pairs, range checks on concentrated positions, and an exit plan if volume dries up. Money you cannot monitor belongs in simpler yield.
Beyond the Basics
If managing ranges and monitoring IL sounds like a job, that is because for professionals it is one. Automated liquidity managers and vaults will run concentrated positions for you — for a fee and with their own smart-contract risk. And if the IL trade-off never sits right with you, remember that simple lending of a single asset earns yield with no impermanent loss at all.