Impermanent loss is the value difference between providing liquidity to an AMM pool versus simply holding the underlying tokens. It's 'impermanent' because the loss is only realized if you withdraw from the pool; if the price ratio returns to the deposit level, the loss disappears. But in practice, many liquidity providers do eventually withdraw at unfavorable ratios and crystallize the loss.
The mathematical cause of impermanent loss is that AMMs rebalance your position as trades happen. If Token A rises 2x while Token B stays flat, the pool sells some of your Token A (to traders buying it) and gives you more Token B — leaving you with fewer appreciating tokens than you started with. The inverse happens when prices decline. In both cases, the LP position underperforms a static HODL.
Impermanent loss scales non-linearly with price divergence. A 2× divergence produces roughly 5.7% IL; a 4× divergence produces 20% IL; a 10× divergence produces over 40% IL. Stablecoin pairs minimize IL because both sides track the dollar. Volatile-paired pools (e.g., ETH/BTC) typically experience modest IL because both assets often move in sympathy.
Fee income is the counter-force. Popular pools generate trading fees that, over time, can more than offset IL. Whether LP is profitable on a net basis depends on: pool volume, fee tier, duration held, and realized price divergence. Always compare LP yield (APY from fees) against expected IL before entering a pool. Concentrated liquidity (Uniswap V3) changes the math significantly — narrower ranges generate higher fees but also higher IL exposure.