When you participate in a liquidity pool by providing assets like NFTs and EGLD, you're exposed to a risk known as 'impermanent loss' (IL). This term refers to the potential decrease in value of your assets when used in a liquidity pool compared to simply holding them. Here's how it works:
What is Impermanent Loss?
Impermanent loss occurs due to the price fluctuation of your assets after they are deposited in the pool. For example, if you deposit NFTs and EGLD, and the price of NFTs increases afterwards, the pool automatically rebalances its holdings.
This rebalancing can lead to a situation where the value of your share in the pool is less than what you would have if you had just held onto your NFTs and EGLD separately.
Earning from Trading Fees:
Despite the risk of impermanent loss, liquidity providers (LPs) earn revenue from trading fees generated in the pool. These fees are a reward for providing liquidity and facilitating trades.
The key to profiting as an LP is to earn enough in trading fees to offset any potential impermanent loss.
Balancing Risk and Reward:
As an LP, you need to weigh the risk of impermanent loss against the potential earnings from trading fees. In some cases, the fees can compensate for the loss in asset value, leading to an overall profit.
It's important to monitor the market and understand that the risk of impermanent loss is higher in volatile market conditions.
In an ideal scenario where no impermanent loss occurs, liquidity providers (LPs) would only earn revenue from the trading fees. However, LPs can still make a profit even with impermanent loss as long as the amount lost is less than the fees earned.
In very simple words:
The risk of impermanent loss in AMM is when you provide your NFTs and EGLD to a liquidity pool instead of holding them. If the NFT price goes up, the liquidity pool may rebalance and you may not earn as much as if you had just held onto your NFTs.