DeFi Market Making: LP Strategies & Spread Trading
Be the house, not the gambler. Market making through LP positions offers consistent fee income, but requires understanding spread dynamics, impermanent loss, and active management to profit.
- LP profitability = fees earned - impermanent loss. Volume matters more than APY displays.
- Start with stablecoin pairs to learn; graduate to volatile pairs once you understand IL.
- Thrive analyzes LP opportunities, estimates IL risk, and finds optimal pools.
Market Making Calculator
Estimate potential returns from providing liquidity:
Key Considerations
- • Tighter spreads = more volume but less profit per trade
- • Inventory risk can wipe out spread profits quickly
- • Gas costs matter on L1—consider L2s for smaller orders
- • Professional MMs use algorithms and hedge exposure
Reality Check: Professional market making requires sophisticated infrastructure, real-time hedging, and significant capital. Manual LP is a simpler form of market making but comes with impermanent loss. Start with stablecoin pairs to learn.
Market Making Fundamentals
Market makers provide liquidity by offering to buy and sell simultaneously. In DeFi, AMMs automate this—you deposit both assets, and the AMM handles the rest.
The Spread Game
Traditional market makers profit from the spread—difference between bid and ask prices.
Bid: $99.50 (you buy here)
Ask: $100.50 (you sell here)
Spread: $1.00 (1%)
If you buy at bid and sell at ask, you profit $1 per share.
AMM LPs earn the equivalent through swap fees—typically 0.3% per trade (split among all LPs).
Why AMM LPing Is Different
- No active quoting: AMM sets prices automatically
- Always on: Your liquidity is always available
- Inventory exposure: Your holdings shift as prices move
- Impermanent loss: You sell winners and hold losers automatically
The Core Trade-Off
Fees Earned - Impermanent Loss = Actual Profit
High volume + low volatility = profitable LP
Low volume + high volatility = unprofitable LP
Reality Check: Many LPs lose money. Studies show 30-50% of Uniswap V3 LPs underperform simply holding. Profitability requires pair selection, timing, and active management.
Understanding Impermanent Loss
What IL Actually Is
When you LP, the AMM rebalances your holdings as prices change:
- If ETH rises: AMM sells your ETH for USDC (you have less ETH)
- If ETH falls: AMM buys ETH with USDC (you have more ETH)
You always end up holding more of the losing asset. IL is the difference between your LP value and what you'd have holding 50/50.
IL Math
IL = 2 × √(price_ratio) / (1 + price_ratio) - 1
Price change → IL:
±25%: 0.6% IL
±50%: 2.0% IL
±75%: 3.8% IL
±100%: 5.7% IL
±200%: 13.4% IL
When IL Hurts Most
- Trending markets: Price moves one direction = IL accumulates
- Low volume pools: Not enough fees to offset IL
- Volatile pairs: Higher price swings = more IL
- Concentrated liquidity: IL amplified within range
Minimizing IL
- Stablecoin pairs: Minimal price divergence = minimal IL
- Correlated pairs: stETH/ETH, wBTC/renBTC
- Wider ranges (V3): Less efficient but lower IL risk
- Active management: Exit before IL gets severe
| Pool Type | IL Risk | Fee Potential | Management | Best For |
|---|---|---|---|---|
| Stablecoin/Stable | Very Low | Low-Medium | Passive | Beginners |
| Correlated (stETH/ETH) | Low | Medium | Passive | Safe yield |
| Blue Chip (ETH/USDC) | Medium | High | Semi-active | Balanced |
| Volatile (ALT/ETH) | High | Very High | Active | Experienced |
LP Strategies
Strategy 1: Stablecoin Base Yield
Setup: USDC/USDT or similar stablecoin pairs
Execution:
- Deposit to stablecoin pools on high-volume DEXs
- Tight range (0.999-1.001) for concentrated liquidity
- Near-zero IL risk
- Collect fees + any incentives
Returns: 3-10% APY, very consistent
Strategy 2: Correlated Pair LP
Setup: stETH/ETH, wstETH/ETH, rETH/ETH
Execution:
- These pairs should trade close to 1:1
- Earn swap fees when arbitrageurs rebalance
- Low IL because prices are correlated
- Bonus: earn staking yield on the LST side
Returns: 5-15% APY including staking rewards
Strategy 3: Range Order Market Making
Setup: Use concentrated liquidity as limit orders
Execution:
- Set range just above (selling) or below (buying) current price
- When price hits range, you're converted while earning fees
- Use for planned entries/exits
Example: Want to buy ETH at $2,000? LP in $1,950-$2,000 range. Earn fees while waiting, get filled if price dips.
Strategy 4: Active Range Management
Setup: Concentrated liquidity with frequent rebalancing
Execution:
- Set tight range around current price
- Earn higher fees from concentration
- Rebalance when price moves outside range
- Requires active monitoring and gas
Tools: Arrakis, Gamma, Bunni for automated management
Advanced Considerations
Hedging IL with Perps
Sophisticated LPs hedge directional exposure:
- LP position gives you long exposure to both assets
- Short perps to neutralize directional risk
- Pure spread income without directional bet
- Complex to manage but reduces variance
JIT Liquidity Competition
Just-In-Time liquidity bots can sandwich your LP:
- Bots add liquidity right before big trades
- Capture fees that would go to you
- Less relevant for small LPs, but erodes edge
Pool Selection Criteria
- Volume/TVL ratio: Higher = more fees per dollar LP'd
- Historical IL: Check backtests for pair volatility
- Fee tier: 0.05% for stables, 0.3% for majors, 1% for exotics
- Incentives: Token rewards can boost returns significantly
Frequently Asked Questions
What is market making in DeFi?
Market making is providing liquidity so others can trade. In DeFi, this means depositing assets into AMM pools. You earn trading fees when others swap through your liquidity. You're essentially running a simplified version of what professional market makers do on exchanges.
How do AMM LPs make money?
LPs earn a share of trading fees proportional to their pool share. Uniswap V2 pools charge 0.3% per swap—LPs split this. More volume = more fees. But LPs also face impermanent loss (IL), so profitability depends on fees earned exceeding IL suffered.
What is impermanent loss?
IL is the difference between holding assets in a pool vs. just holding them. When prices diverge, your pool position is worth less than if you'd held. It's "impermanent" because it reverses if prices return to entry. But if you withdraw during divergence, the loss becomes permanent.
How does concentrated liquidity change market making?
Concentrated liquidity (Uniswap V3) lets you provide liquidity in a price range, not across all prices. This increases capital efficiency—you earn more fees per dollar deployed. But IL is also amplified if price leaves your range, and you need active management.
What pairs are best for LPing?
Low IL risk: stablecoin pairs (USDC/USDT), correlated pairs (stETH/ETH). Higher fee potential: volatile pairs but with high volume. Best balance: high-volume pairs where you understand the volatility (ETH/USDC on active pools). Avoid low-volume pairs—fees won't cover IL.
Should I provide liquidity on V2 or V3 pools?
V2: Simpler, passive, spread across all prices. Good for pairs you expect to mean-revert. V3: Higher fees but requires active management and tighter ranges. Better for range-bound pairs or if you'll actively manage. Start with V2 to learn, graduate to V3.
How do I manage inventory risk?
Inventory risk is exposure to one asset in your LP position growing while the other shrinks. Mitigation: (1) LP pairs you're comfortable holding both sides, (2) Hedge directional exposure with perps, (3) Choose ranges that keep you balanced, (4) Set exit thresholds for rebalancing.
What are the real yields from LPing?
Highly variable. Top pools: 5-50% APY from fees (volatile, high-volume pairs). Stablecoin pools: 2-10% APY. But after IL, many LPs underperform simple holding. Only ~30-50% of LPs are profitable after IL. Success requires pair selection and timing.