Impermanent loss

It is called impermanent because it disappears if prices return to the initial ratio. In a constant-product AMM such as Uniswap v2 the formula x times y equals k applies, and the pool price is the ratio of the reserves. When the external price moves, arbitrageurs rebalance the pool to match the market, and in that process the provider ends up with more of the depreciating asset and less of the appreciating one.

For a 50/50 pair, a 2x move in price produces roughly 5.7% less value than holding. The key property is that the loss depends only on the magnitude of the price change, not its direction: up or down, there is loss. The offset is trading fees and farming incentives, so the provider's net result is fees minus impermanent loss.

It is the fundamental risk of liquidity provision in AMMs and of much of yield farming. There are real, well-known mitigations: pools of correlated assets, such as stablecoin with stablecoin or ETH with stETH, where divergence is minimal. Curve Finance optimizes exactly this case with its StableSwap, while Uniswap v3 (May 2021) lets providers concentrate liquidity in ranges in exchange for amplifying it inside the active range.