Yield farming has become one of the most attractive aspects of decentralised finance. It offers crypto users a way to earn passive income by supplying liquidity to protocols that facilitate trading, lending, or other on-chain activities. However, one of the least understood and often underestimated risks of yield farming is impermanent loss. If you provide liquidity to an automated market maker (AMM) and the relative prices of the assets diverge, you might earn less than if you had simply held the tokens in your wallet.
Understanding how to avoid impermanent loss in yield farming is essential for building a sustainable DeFi strategy. It requires a combination of asset selection, platform knowledge, active monitoring, and, in some cases, choosing more advanced protocols with built-in mitigations. In this article, we explore what impermanent loss is, why it happens, and what strategies can help reduce its impact without giving up the rewards that make yield farming attractive.
What Is Impermanent Loss?
Impermanent loss occurs when the price of one or both assets in a liquidity pool changes relative to the other. In most AMMs like Uniswap or PancakeSwap, liquidity is provided in equal value parts of two assets. If one token increases significantly in price, arbitrage traders will rebalance the pool by trading against it. As a result, the liquidity provider ends up holding more of the underperforming token and less of the appreciating one.
The term “impermanent” refers to the fact that this loss only becomes permanent if and when the user withdraws their liquidity at the time of divergence. If prices return to their original ratio, the loss disappears. But if you withdraw while the tokens have diverged in value, you realise the loss compared to simply holding the tokens outside the pool.
In practice, impermanent loss can range from negligible to severe. A 100% price increase in one asset relative to the other can result in over 5% loss compared to holding. If the price change is more extreme, the loss grows. This effect is not visible in your wallet balance but becomes clear once you compare your liquidity position’s value to the value of the same tokens if held separately.
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 and Carbon Finance 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.
Final Thought: Managing Risk While Earning Yield
Learning how to avoid impermanent loss in yield farming is essential for making smarter decisions in DeFi. The goal is not necessarily to eliminate the risk, but to manage it thoughtfully while continuing to earn meaningful returns. Whether you choose stablecoin pairs, protocol-protected pools, concentrated liquidity, or timing strategies, the key is to understand how impermanent loss fits into your broader risk-reward framework.