Liquidity Providing on AMMs

Providing liquidity to an automated market maker means depositing assets into a pool whose trading rule determines the inventory you own as prices change. This guide explains a constant-product example. It does not describe a deposit product or promise a yield.

Identify the mechanism before contributing

Uniswap v2's design uses a constant-product reserve relationship and distributes trading fees to liquidity providers through the pool.[1] Other AMMs can use different curves, ranges or incentive rules. Polymarket's current trading documentation describes a central limit order book, so its market-making and reward programs should not be treated as an AMM deposit.[2]

For any pool, identify both assets, the pricing rule, fee treatment, withdrawal mechanism and settlement dependency. An outcome token that eventually becomes worthless is economically different from a pair of assets expected to retain value.

Understand how inventory changes

In a simplified constant-product pool, reserves x and y satisfy x × y = k before fees. Traders remove one asset and add the other. A liquidity provider consequently holds more of the asset being sold into the pool and less of the asset being purchased. The position is not equivalent to leaving the original quantities untouched.[1]

Suppose a fee-free pool begins with one token and $100, with the token worth $100. If the token's external price doubles and arbitrage aligns the pool price, the pool holds approximately 0.7071 token and $141.42. Its total value is about $282.84. Holding the original token and $100 would be worth $300. The difference is approximately 5.72% of the holding benchmark.

For this specific symmetric constant-product example, relative value is 2 × sqrt(r) / (1 + r), where r is the token's price ratio. Subtract one to express the difference from holding. This formula does not automatically apply to concentrated liquidity or every prediction-market AMM.

Compare fees with inventory risk

Trading fees can offset some of the difference, but volume alone is not profit. Track pool ownership, deposited and withdrawn amounts, rewards and a consistent holding benchmark. Fees and rewards are different mechanisms; consult the exact program rather than applying a headline rate from another venue.[3]

Stress-test a one-sided outcome

For binary outcome tokens, examine what happens as one side approaches a zero payout. Ask whether the pool can be withdrawn before or after resolution, what remains to redeem, and what a protocol or oracle failure would mean. A loss relative to holding can persist when the economic outcome is final; the word "impermanent" is not an assurance of recovery.

Use only a mechanism you can account for through its entire lifecycle. If the payoff cannot be explained in a simple ledger of asset quantities and cash flows, more advertised rewards do not make the exposure easier to manage.

References

1. Hayden Adams, Noah Zinsmeister and Dan Robinson. Uniswap v2 Core. Uniswap, March 2020. Protocol design paper.
2. Polymarket Documentation. Prices & Orderbook. Accessed October 13, 2026.
3. Polymarket Documentation. Fees. Accessed October 13, 2026.