1. The Setup: The 50/50 Rule

To understand the loss, first, you must understand how a standard Liquidity Pool (like on Uniswap) works. When you become a Liquidity Provider (LP), you cannot just deposit one coin. You must deposit two assets of equal value.

• Example: If 1 ETH is worth $500, you must deposit 1 ETH and 500 DAI (a stablecoin worth $1).
• Your Position: You now own a share of a pool that holds a 50/50 balance of these two items.

Link to the next concept: So, your money is in the pool. What happens when the price of ETH changes on the outside market? This leads to Arbitrage.

2. The Trigger: Arbitrage

Automated Market Makers (the pools) are passive. They don't instantly know that the price of ETH went up on Coinbase or Binance. They rely on traders to tell them.

• The Scenario: Imagine the price of ETH shoots up to $550 on the open market. However, inside your liquidity pool, the price is still sitting at the old rate of $500.
• The Arbitrageur: A trader sees this. They realize they can buy ETH from your pool for $500 and instantly sell it outside for $550.
• The Action: They buy ETH from the pool (removing ETH) and pay in DAI (adding DAI).

Link to the next concept: The trader made a profit, but at your expense. This changes the composition of your wallet.

What is Arbitrage?
**Buying an asset in one market and simultaneously selling it in another market at a higher price to profit from price differences**.

3. The Result: Impermanent Loss

Because the trader bought the cheap ETH from the pool, the pool now has less ETH and more DAI than when you started.

The "Loss" Calculation: If you had simply kept your 1 ETH in your wallet (HODL), you would now have $550. However, because your ETH was in the pool, some of it was sold off to the trader as the price went up. You now hold a mix of assets that is worth slightly less than if you had just done nothing.

• The Rule: The more the prices diverge (go up or down) from the moment you deposited, the more "value" you lose compared to simply holding.

Link to the next concept: You might be asking, "If I lost money, is it gone forever?" Not necessarily. That is why it is called Impermanent.

4. The Name: Why "Impermanent"?

The loss is only "realized" (made permanent) if you withdraw your money from the pool right now.