Impermanent Loss (IL) is when the prices of the two tokens diverge. This happens while the liquidity position is active, resulting in a loss of the liquidity position value.
Liquidity pools on the Uniswap Protocol require that the pool has a constant
k represents the liquidity that has been provided.
The smart contract for the liquidity pool maintains a constant using the following function:
x = token0
y = token1
k = constant
During each swap, an amount of one token is removed from the pool for an amount of the other token. To maintain
k, the balances held by the smart contract are adjusted during the swap.
These prices also diverge through other pools and exchanges. As a result of the divergence in prices, the liquidity balance also changes.
The price may or may not return to the price you provided liquidity at. If it doesn’t return to the original price that you provided, this is considered impermanent loss.
Can a concentrated liquidity position amplify impermanent loss?
In most cases, a concentrated range means there is a greater chance of impermanent loss.
Although, with Uniswap v3, a liquidity provider can provide liquidity across many concentrated ranges in a pool. This may lessen the impact of impermanent loss.