AMMs and liquidity pools: trading against a formula

Trading against a formula

An automated market maker holds two (or more) tokens in a pool and quotes prices from a fixed curve instead of matching buyers with sellers. You always get a fill — the question is only the price, which worsens as your trade eats into the pool's balance. Small tickets barely move it; large ones do.

Why pools need you and pay you

Liquidity providers deposit both sides of a pair so traders have something to swap against. In return they collect a cut of every trade's fee, proportional to their share. Yield is real revenue from flow — plus, often, token incentives that can vanish without warning. Separate the two before judging any "APY".

Impermanent loss, plainly

If the tokens' prices drift apart, the pool's formula sells the winner and buys the loser relative to just holding. That gap — versus holding both tokens outside the pool — is impermanent loss: "impermanent" only because it shrinks if prices reconverge, which you cannot count on. Fees must out-earn the drift, or the LP loses to the holder.

The checklist before providing liquidity

Volatile pairs drift hardest; stable pairs drift least but pay least. Concentrated positions multiply both fee capture and loss. Never LP a token you would not hold outright — the pool will hand you more of whichever side underperforms.

Risk note: cryptocurrency trading, leveraged perpetual futures, and automated algorithmic strategies carry significant risk of rapid and total financial loss. Never risk funds you cannot afford to lose completely. Nothing in this lesson is investment advice, a recommendation, or an offer to sell any product.