How liquidity pools work: swaps, LP shares and price ranges

A pool connects traders and liquidity providers

A trader wants to exchange one asset for another. A liquidity provider supplies assets to a program that makes an exchange available under defined rules. The provider receives a position representing its rights in that mechanism.

The pool's holding accounts contain tokens, while other program state records configuration, reserves or positions. An AMM calculates the permitted exchange instead of requiring another user to place a matching order at that instant.

Different AMM designs use different calculations. Constant-product pools provide a useful first model. Concentrated-liquidity pools add range-specific liquidity, and other specialised markets have their own rules. The label pool does not identify a universal invariant or fee schedule.

Before adding assets, identify both mints, the actual program and the type of position you will hold. These determine how a quote, fee and withdrawal should be interpreted.

Derive a fee-free constant-product swap

Choose teaching reserves of 100 X and 10,000 Y. Their product is 1,000,000. In the simplified fee-free constant-product model, a trade keeps that product constant.

A trader adds 10 X. The pool then has 110 X, so its new Y reserve is 1,000,000 divided by 110, about 9,090.91 Y. The output is the difference from the old 10,000 reserve: about 909.09 Y.

The initial marginal price was 100 Y per X. The finite trade receives about 90.91 Y per X on average because it moves along the curve. The output was determined by the reserves and chosen size before any quote-to-execution delay.

Actual programs apply integer arithmetic, fees and their accounting rules. This example intentionally removes those components to expose the mechanism. Use the venue's real state and contract to calculate an executable quote.

The provider’s asset mix changes

Suppose a provider owns 10% of our teaching pool and there are no other liquidity changes. Before the trade, that share corresponds to 10 X and 1,000 Y. Afterward, it corresponds to 11 X and about 909.09 Y, ignoring fees and rounding.

The share can stay at 10% while the asset quantities change. That is the economic exposure the provider accepted by making inventory available to traders.

To assess performance, compare the position with a defined alternative, such as retaining the original 10 X and 1,000 Y over the same interval. Value both at the same chosen time and price source.

The difference from a holding benchmark is often discussed as impermanent loss. The name does not promise that the difference will disappear. Fees can offset part of the divergence, while price movements and costs still determine the net result.

A 10% share changes composition

Calculate impermanent loss against holding the original assets

Use a separate fee-free scenario starting from the same 100 X and 10,000 Y reserves. The initial marginal price is 100 Y per X. Suppose the external price doubles to 200 Y per X and arbitrage brings this full-range constant-product pool to that price. Assume no deposits, withdrawals, fees or other changes.

The reserve product stays 1,000,000, while Y / X becomes 200. Solving the two conditions gives about 70.710678 X and 14,142.135624 Y. Valued at 200 Y per X, the pool contains about 28,284.271247 Y of assets.

Holding the original 100 X and 10,000 Y outside the pool would instead be worth 30,000 Y. The pool's value is about 5.7191% lower than that holding benchmark, even though it rose from its initial 20,000-Y value. This is divergence relative to a chosen alternative, not necessarily a loss relative to the original deposit value.

A provider owning 10% has the same percentage comparison before fees and rounding. Trading fees or incentives can offset some divergence; costs or other losses can worsen the net outcome. Add those components separately rather than assuming that a positive fee counter proves outperformance.

The familiar full-range formula does not describe every concentrated-liquidity position. A selected range changes the inventory path and can leave a position one-sided. Use the actual range, liquidity and fee accounting for that product. The LP return guide shows how to compare the completed position with holding over the same period.

Read the fee allocation for the actual product

Traders can pay fees under the pool's configuration. Some portion can accrue to liquidity providers, while other portions go elsewhere according to the program. Read the actual allocation rather than assigning every charged unit to your position.

A pool-wide fee total is not your personal income. Your share of active liquidity and the path of trades determine the relevant allocation. Concentrated positions can differ substantially even in the same pool.

Check whether the interface includes accrued fees in the displayed position value or shows them separately. Adding both without reading that definition can count one income amount twice.

Token incentives add another asset and distribution mechanism. Keep their quantity, claimability and valuation separate from organic trading-fee income.

Concentrated liquidity makes the price range part of the position

A concentrated position specifies lower and upper price bounds. It supplies liquidity to the relevant trading path while active in that range. Its asset composition evolves as price moves through the range.

For a teaching X/Y position, express price as Y per X. Below the chosen range, the position's principal can be entirely X; above the range, entirely Y, ignoring separately accrued fees. Inside the range it holds a mix according to the program's math.

Outside its active range, the position does not provide the same trading liquidity or earn the associated in-range trading fees. Other incentive rules are separate. Re-entering the range or rebalancing can change that exposure.

A narrower range concentrates liquidity but also changes how soon the position becomes one-sided or inactive. Automated rebalancing performs a strategy with real swaps, fees and permissions; it is not a free reset of the market outcome.

Follow entry, observation and exit

For entry, inspect the required assets, amounts, selected range where relevant, setup funding and position token or account. Verify the result after execution.

For observation, record current asset quantities, range state, accrued fees and other rewards. Keep deposits, withdrawals and rebalances in the history.

For exit, inspect the quantities actually returned. Converting them into only SOL or USDC is another trade and needs its own quote. A position's displayed value does not promise that conversion at exactly the shown reference price.

The net-return guide turns these records into a financial result, and price impact explains the trader's side of the same liquidity.

Common questions