Impermanent loss describes how an automated market maker liquidity position can become worth less than simply holding the original deposited assets. The comparison measures a shortfall against that holding alternative, not necessarily a fall below the initial investment. A position can gain in dollar value and still experience impermanent loss.
Why the asset mix changes
As prices move, trading and arbitrage change the quantities held in the pool. A conventional constant-product pool sells some of the relatively appreciating asset and accumulates more of the other asset. The provider consequently ends up with a different mix from the original deposit.
For an unchanged 50/50 constant-product position, if one asset doubles relative to the other and the pool adjusts to that price, the shortfall is approximately 5.72% of the holding alternative's value, excluding fees, incentives, and costs. Other pool designs and concentrated ranges produce different results.
Why the name can mislead
Returning to the original price ratio can reverse this shortfall in the simple model, but recovery is not guaranteed. Withdrawal realizes the position's current asset mix. Trading fees may offset the shortfall, yet depegging, sustained divergence, and concentrated liquidity can increase exposure. Assessing total performance requires including all income and expenses.