Impermanent loss occurs when you provide liquidity to an automated market maker (AMM) and the price of your deposited assets changes compared to when you deposited them. The greater the price divergence, the greater the impermanent loss.
How It Happens
When you deposit two tokens into a liquidity pool at equal value, the AMM automatically rebalances the ratio as prices change. If one token's price rises significantly, the pool sells some of it for the other token. When you withdraw, you end up with less of the appreciated token and more of the depreciated one than if you had simply held.
Why "Impermanent"
The loss is called "impermanent" because it only becomes permanent when you withdraw your liquidity. If prices return to their original ratio, the loss disappears. However, in practice, prices often don't return to their original ratio.
Mitigating Impermanent Loss
Provide liquidity for stablecoin pairs (minimal price divergence), choose pools with high trading fees to offset the loss, or use concentrated liquidity positions on platforms like Uniswap V3.