When you are Providing Liquidity (LPing) you are "making the market" for a particular trading pair, meaning you are acting as the liquidity for buyers and sellers on DEXes while earning fees. The market is constantly moving up and down. Meaning the ratio of assets you are Providing Liquidity is constantly changing, as you are buying and selling them. If we take the example of LPing ETH/USDT, as ETH goes up, you are "buying" USDT. So in this LP you will start having more and more USDT, meaning that you have less ETH resulting in you having less exposure on ETH. While this is happening you earn both ETH and USDT fees.
Now let's add volatility to the equation and take an example with ETH/USDT. Imagine the following: you have been providing liquidity to the ETH/USDT pair since March. The LP ratio you have is 60/40 ETH/USDT. As price reached an all time high in May, your LP bought more USDT, so you might now be at an exposure of 20/80 ETH/USDT. This is what you call Impermanent Loss (IL), which makes people panic.
But wait! Let's dive into what happens if the price moves down again!
Let's now imagine a huge price crash, in this case prices came crashing down to the same levels as in March. As price goes down your LP is buying more and more ETH. So now in July you may be at the same ETH/USDT ratio. This is why Impermanent Loss is called “Impermanent”. You are not losing anything if you wait for the ratio to come back to your entry point to dismantle your LP.
During this time from March to July, you have been earning trading fees, while the LP you have is "buying" and "selling" the assets you have provided. If you had been LPing in the example above, you would have ended up with the same ETH/USDT ratio as you started + fees.
Now there's one more thing to add to this equation to fully grasp its potentiality. Stable/Stable, WBTC/ETH, AVAX/SOL etc are more correlated pairs, meaning their prices usually move in the same direction. In other words, the ratio between these coins in an LP are not as volatile as uncorrelated pairs, producing less IL. If you are bullish on the overall crypto market, you want to be LPing WBTC/WETH rather than ETH/USDT basically.
Understanding Returns and APRs
Earning fees with LPing, is NOT like staking/farming, since the assets you are holding change in proportion constantly.
Remember that we can not predict the future return on LPing as it is completely based on how the market moves. It’s impossible to find out how much fees your LP will produce, because it is impossible to predict the future.
This is the reason why our APRs are only a projection, based on past values!
Sorbetto Fragola and Impermanent Loss
A small appendix needs to be made for Sorbetto Fragola strategy and how it relates with IL. Working on UniV3 positions, Fragola rearranges the boundaries of the ratio in which your funds are being LPd, based on price movement. This means that it is also making the Impermanent Loss permanent every rebalance in order to remain in the most traded utilisation range and capture the most fees! The tighter the range, the higher the amount of fees collected, but also the higher the IL exposure as more rebalances will be required.
See Fragola range as the optimal trade off between maximizing fees earnings, trying to keep the Impermanent Loss exposure as low as possible.