Impermanent loss occurs when you provide liquidity to an automated market maker (AMM) pool and the price of one token changes relative to the other. The AMM rebalances your token holdings to maintain a constant product, meaning you end up with more of the cheaper token and less of the expensive one compared to simply holding.

The standard formula for impermanent loss is: IL = 2 * sqrt(priceRatio) / (1 + priceRatio) - 1, where priceRatio is the current price divided by the initial price. This formula applies to constant-product AMMs like Uniswap v2. The loss is "impermanent" because it only becomes realized when you withdraw from the pool; if prices return to the original ratio, the loss disappears.

For example, if you deposit $10,000 into a 50/50 ETH/USDC pool when ETH is $2,000 and ETH rises to $3,000 (a 1.5x ratio), the impermanent loss is approximately 2.02%. Your pool value would be about $12,247 compared to $12,500 if you had simply held, resulting in a loss of about $253. Trading fees earned from the pool may offset or exceed this loss.