In simple terms — If you place two tokens in a pool and their relative price changes, the AMM automatically changes the quantities you hold. When you withdraw, your position may be worth less than if you had simply kept the same tokens.
Impermanent loss is not a fee charged by the protocol. It is a relative loss: it compares the value of a liquidity-provider position with the value that the same initial basket would have had outside the pool. An LP position can therefore make money in currency terms and still underperform holding.
Why the composition changes
In an AMM, arbitrageurs trade against the pool until its price moves close to prices in other markets. If one token rises relative to the other, the pool tends to hold less of the stronger token and accumulate the relatively weaker one. The greater the price divergence, the larger the gap from the basket that was not deposited may become.
The word “impermanent” can be misleading. If prices return to their initial ratio before withdrawal, the gap may shrink; if the LP withdraws while it persists, the comparison is effectively realized. In concentrated-liquidity pools, the result also depends on the chosen range. Outside that range, the position may become almost entirely composed of one asset and stop earning fees.
Net results include several components
To assess a position, add the fees and incentives received, then subtract impermanent loss, transaction costs, applicable taxes, and other losses. High fees can offset the shortfall, but they do not do so by definition, and past returns do not guarantee the same future trading volume.
A correct comparison uses the same initial capital, the same period, and consistent prices. Showing only the pool's APR hides the main variable. Before depositing, it helps to model price scenarios, understand whether the assets are correlated or stable, and check whether either can lose its peg. Impermanent loss also excludes smart-contract and rug-pull risk: those are separate risks.
Sources
- Uniswap Docs — Understanding Returns — Compares LP returns, fees, and the loss relative to holding the assets.
- Uniswap — V2 whitepaper — Sets out the economics of the constant-product AMM.
- Uniswap — V3 whitepaper — Specifies ranges, concentrated liquidity, and position composition outside the selected range.