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Liquidity Pool: Profit, Loss Defination
Friends, whenever we hear about Liquidity Pool, we do not understand one question - if I invest money, will it increase or decrease? I also watched many videos on YouTube but I did not understand anything special, but I read many posts and understood them myself, only then I came to know what is Liquidity Pool and how it works and how it gives us passive income. It said there is a risk in knowing all this. Here today I will explain it to you with some examples and so that new users can understand it well, in this way I will tell it in this post today so that people can join here and take advantage of passive income.
What is Liquidity Pool?
Liquidity Pool means that there is a pool of 2 coins. Where people put coins, this is so that other people can trade easily. Where people can easily buy-sell (swap). Due to this, people who deposit coins get profit (reward fees). This practice mostly happens on DEX (Decentralized Exchange). For example Hive Engine,Tribaldex. Here the people who put coins in the pool are called Liquidity Providers. Here you have to enter 2 coins like hive - clone token. Here the automatic system will tell you how much coin you have to take so that the calculations are equal. This means that you have to buy the same quantity of 2 coins. If you have taken Colony Token 10 then you will have to take the same Heave.
What did I put on the Liquidity Pool?
Here you have to put 2 coins in the liquidity pool. For example, hive-colony token is inserted. What will happen here? You will be connected to your wallet. Then you will not have these coins in your wallet. Your coins will be locked inside the pool. They will remain locked inside until you let them out. Here you will get Liquidity Pool Share in exchange. All you have to do is put your coins in the pool. You have to do this work.
What happens in the pool?
When a user swaps Hive for Colony or Colony for Hive, they pay a small fee on each transaction. The exchange does not keep this fee. Instead, the fee goes to the liquidity providers—the people who have invested their coins in the platform. This is where the coin swapping takes place and the fees generated are distributed to the liquidity providers.
How to earn money in Liquidity Pool
Fees – Here friends, whenever a user makes a transaction, there is a fee for every transaction on whatever token he is purchasing. You get that fee according to your share. Here you get income in the form of fees. Here, if the user swaps the coins where you have deposited them, you get good money as his fee.
NOTE - A small transaction fee (varies by platform)
APR / Rewards - Here friends, when you put a coin in the Liquidity Pool, then the Liquidity Pool gives you some coins which you can call a reward. This reward is not deposited in the Liquidity Pool, you get it whenever you withdraw the coin. Rewards do not add up to the liquidity pool. You get these separately. On most platforms you have to make a claim.
Here you can also suffer a loss, that is, you cannot say loss here, here only the quantity of the coin decreases, which means as the rate of the coin increases, the quantity of that coin decreases. The value may go up or down when the price changes. As I told you, the quantity of coins in the Liquidity Pool can change. This is called Impermanent Loss not Permanent Loss.
This loss can be covered.
- fees and rewards
- cover this loss many times over
Impermanent Loss – Example
You deposited 10 HIVE 10 Colony tokens into the Liquidity Pool.
Hive 10* 10=100
Colony 10* 10=100
Now the price of Hive has increased which means -
Hive 10* 20=200
Colony 10* 10=100
What the liquidity pool will do is keep the value of both coins equal. He will equalize the value of both, meaning now there are coins worth a total of Rs 300. Now he will sell them to Hive, meaning the coin whose price will increase will be sold. Now here
{ 7.5 * 20 = 150 }
{ 15 * 10 = 150 }
This means that here you have reduced your Hive tokens, this is not your loss but you have suffered an impermanent loss. These losses can be covered by the reward fees and you get good profits from it. If you take out your coins after seeing this loss, you incur a loss and if you hold it, you can recover from the reward fee and earn good profit.
Important Note - For simplicity this example is for understanding. Actual pool calculations are done automatically by AMM formula.
Why does this loss happen?
Because Liquidity Pool automatically balances the coins as soon as the price changes, here it increases another coin by selling it. In this process here, your total value becomes less than the holding. Here the question arises whether money is really lost? So my answer is no because impermanent loss is temporary. You suffer this loss when you withdraw. If the price comes back to the same level then this loss can be eliminated on its own.
How is it covered?
Here they can cover the losses through trading fees. Here, fees are paid on every transaction which are deposited in the liquidity pool. You get APR/Rewards which gives you good income in the form of tokens. Often these earnings covers or exceeds the impermanent loss.Impermanent loss is not a real loss until you withdraw from the pool.
Which people is it right for?
It is good for long-term thinkers who do not look at the daily price. Those who can give time to coins for a long time, those who believe in giving time to coins. Here you have to be patient, if patient users are not worried about price up-down, that means market up-down does not make any difference. It is profitable for those who consider short-term investment as a loss. For those choosing high volume pools where there is more trading. More fees are generated.Impermanent loss is easily covered. This is perfect for those who want passive income - those who want the coins we have liked to work and earn without doing daily trading. Here we do not have to do any hard work and our money keeps coming, this is absolutely right for them.
For which people is it not suitable?
It is not made just for people waiting for a price jump. They should stay away from it as it can cause harm.
Those who do not have knowledge of liquidity pool should also stay away. If you do not understand this then it will be your loss.
Whatever trade you are doing, you should not be emotional or panic. If you think that I panic too much then stay away from it, first learn and then you come here.
NOTE -This post is written in my own words based on my understanding and learning.