What is Liquidity Provisioning? Beginner's Guide
Liquidity provisioning means depositing tokens into a trading pool so others can swap against them. In return, you earn fees from every trade that uses your liquidity. It's like being a mini market maker. The main risk is impermanent loss—when price moves, you might have been better off just holding.
Table of Contents
Quick Answer
You put tokens in a pool. Traders swap against your tokens. You earn a cut of swap fees. If price moves significantly, you lose value compared to just holding (impermanent loss). Net result = fees earned minus impermanent loss.
How liquidity pools work
On decentralized exchanges, there's no order book with buyers and sellers. Instead, pools of tokens enable trading.
Basic mechanics
- Someone deposits Token A and Token B into a pool
- Another user wants to swap Token A for Token B
- They trade with the pool, putting in A and receiving B
- The pool now has more A and less B
- Price adjusts based on the new ratio
The people who deposited tokens are liquidity providers (LPs). Without them, no trading happens.
Why it works: The pool's math ensures there's always a price available. No need to find a counterparty. Just trade with the pool.
Why pools pay you fees
Every swap pays a fee (typically 0.1% to 1% depending on the pool). This fee goes to LPs proportional to their share of the pool.
Example:
- Pool has $100,000 total liquidity
- You provided $10,000 (10% share)
- Someone swaps $50,000 at 0.3% fee ($150)
- You receive 10% of $150 = $15
Do this thousands of times and the fees add up. High-volume pools generate more fees. Your share of fees depends on your percentage of the pool.
Fee rates vary
- Stablecoins: 0.01-0.05% (low volatility, low fees)
- Major tokens: 0.1-0.3%
- Memecoins: 0.3-1% (high volatility, high fees)
Understanding impermanent loss
Here's the catch: when you LP, you're exposed to price movements in a way that's often worse than just holding.
Why it happens
When you deposit, you provide equal values of two tokens. Say $5,000 SOL + $5,000 USDC.
If SOL doubles, the pool rebalances. You now have less SOL and more USDC than when you started. You still have gains, but less than if you'd just held SOL.
If SOL halves, same thing but reversed. You have more SOL and less USDC, but more SOL at a lower price means you're down more than just holding USDC.
The math:
- At 2x price change: ~5.7% impermanent loss
- At 4x price change: ~20% impermanent loss
- At 10x price change: ~42% impermanent loss
Why "impermanent"?
If price returns to your entry point, the loss disappears. It's only permanent if you withdraw while at a different price.
Net result: Fees earned minus impermanent loss. If fees >IL, you profit. If IL > fees, you lose.
Types of LP positions
Traditional AMM (Full range)
Your liquidity covers all prices from 0 to infinity. Simple but capital inefficient. Most of your capital sits unused.
Best for: Passive LPs who don't want to manage positions. Stablecoin pairs.
Concentrated liquidity (DLMMs)
You choose a price range. Your capital concentrates there. Higher fee earnings within range, but zero earnings outside.
Best for: Active LPs who can manage positions. Volatile tokens where you have a view on trading range.
Single-sided liquidity
Some pools let you deposit just one token. The pool pairs it with another. Easier entry but same risks apply.
Best for: When you only have one token and want exposure to LP fees.
Getting started as an LP
Step 1: Choose your pool
Consider:
- Fee tier: Higher fees = more earnings but often more volatility
- Volume: Higher volume = more trades = more fees
- Volatility: More volatility = more impermanent loss risk
- Range (if DLMM): Tighter range = more capital efficiency but more management
Step 2: Prepare your tokens
For traditional pools, you need equal value of both tokens. For concentrated liquidity, the ratio depends on your range.
Step 3: Add liquidity
Connect your wallet to the DEX (Meteora, Orca, Raydium). Navigate to the pool. Enter amounts. Approve transaction.
Step 4: Monitor and manage
Check your position regularly. For DLMMs, ensure price is still in range. For all pools, track fees earned vs impermanent loss.
Step 5: Withdraw when appropriate
You can remove liquidity anytime. You'll receive the current ratio of tokens plus earned fees.
Is LPing right for you?
Good candidates for LPing
- You plan to hold both tokens anyway
- You have time to monitor positions (for DLMMs)
- You understand the math and risks
- You're okay with potentially underperforming simple holding
Poor candidates for LPing
- You're bullish on one token and want full upside
- You can't check positions regularly
- You don't understand impermanent loss
- You're already overexposed to volatile tokens
Questions to ask yourself
- Would I hold both tokens regardless of LP?
- Can I afford to underperform simple holding?
- Do I have time to manage this position?
- Am I okay with potential losses beyond price decline?
Common beginner mistakes
1. LPing tokens you don't want to hold
If you're only LPing for fees but hate one of the tokens, you'll end up with lots of that token after a price move. Only LP pairs you're comfortable holding.
2. Setting too tight ranges
You maximize efficiency at the cost of constant management. Price leaves your range in hours, you earn nothing, and you're exposed to IL. Wider ranges are more forgiving.
3. Ignoring impermanent loss
"I'm earning 50% APY!" Sure, but if IL is 60%, you lost money. Always calculate net returns, not just fees.
4. Not tracking performance
Without tracking, you won't know if you're profitable. Use portfolio trackers or spreadsheets to monitor actual performance vs just holding.
Frequently Asked Questions
How much can I earn from LP?
Depends on fees, volume, and impermanent loss. Some pools earn 10-50%+ APY. Some lose money. There's no guaranteed return.
Can I lose all my money?
If both tokens go to zero, yes. If one token rugs, you'll hold mostly that worthless token. LPing doesn't protect against token failure.
How often should I check my LP position?
For traditional AMMs on stable pairs: weekly. For DLMMs on volatile tokens: daily or more.
Quick Reference
- Profit = fees earned minus impermanent loss. Track both.
- 2x price change = ~5.7% IL. 4x = ~20%. 10x = ~42%.
- Concentrated ranges earn more per dollar but go out of range faster
- Only LP pairs you'd hold anyway
See Where LPs Are Positioned
Before adding liquidity, see where other LPs have placed their capital. CLOBr shows you the full liquidity landscape so you can find the best ranges.
Try CLOBr Free