Impermanent loss (IL) is the difference between the value of tokens held in a liquidity pool and the value of simply holding those same tokens outside the pool. It occurs when the price ratio of the deposited tokens changes after deposit.

When token prices diverge, the AMM rebalances the pool by selling the appreciating token for the depreciating one. This means LP holders end up with less of the token that increased in value than if they had simply held it. The loss is 'impermanent' because it reverses if prices return to the original ratio.

Impermanent loss is more severe for volatile token pairs and for concentrated liquidity positions where capital is outside the active price range. Trading fee income can offset IL if trading volume is high enough.