Impermanent loss is the most misunderstood number in automated market making. It is not money disappearing; it is the gap between providing liquidity and holding the same assets untouched.
The pool rebalances without deciding to
An automated market maker holds two assets and quotes prices from their ratio. Traders take whichever side is cheap and add the side that is expensive.
So as one asset rises, the pool ends up holding less of it and more of the other. Nobody chose this; it is what the pricing formula produces.
A liquidity provider owns a share of the pool, so their position follows that shifting composition automatically.
The comparison is against holding, not against zero
Impermanent loss is measured against a wallet that simply kept both assets. If prices rise, a liquidity position usually rises too, just by less.
The word loss describes underperformance relative to that baseline, which is why positions can show impermanent loss while their value has increased.
The effect is also symmetric. A pool gives up part of the upside when one asset rallies and cushions part of the drawdown when it falls, because it has been selling into strength and buying into weakness all along.
It becomes permanent at withdrawal
While the position stays open, the divergence can reverse. If the price ratio returns to where it started, the gap closes and the position matches what holding would have produced.
Withdrawing crystallises whatever composition exists at that moment. That is the point where the difference stops being a paper comparison and becomes the actual mix of assets you walk away with.
The name reflects that possibility of reversal, though it flatters the situation. Where a token drifts steadily in one direction and never comes back, there is nothing impermanent about the outcome.
Fees are the other side of the ledger
Providers earn a cut of every trade routed through the pool, and that income accrues regardless of which direction prices move.
Whether a position was worthwhile depends on whether accumulated fees exceeded the divergence. High volume relative to pool size favours the provider; a quiet pool in a moving market does not.
Neither side is known in advance, which is why liquidity provision is a position with its own risk profile rather than a way of earning interest on assets you already hold.
Asset choice determines the size of the effect
The gap grows with how far the two prices diverge, so pairs that move together produce little of it and pairs that move independently produce a great deal.
This is why pools of similarly priced assets can run on thin fees while volatile pairs need much higher ones to compensate providers.
Concentrated liquidity designs change the arithmetic but not the principle: narrowing the range earns more fees per unit of capital and increases exposure to divergence.