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As Caviar utilizes the AMM model, liquidity providers supply equal amounts of NFTs and ETH to earn yield. The AMM will automatically adjust the price in the pool of your assets each time a buy or sell occurs. Impermanent loss (IL) occurs when you provide liquidity to a liquidity pool and the price of the assets changes compared to when you deposited them. The less volatile the deposited assets are, the less IL there will be. Note that these “losses” are impermanent, meaning they aren’t realized until you withdraw your liquidity position. If the prices of the assets deposited move back to the initial deposit values, your IL would be 0. Let's say you deposit 1 ETH and 1 ETH worth of NFTs and the value of the NFT rises in ETH terms. Your liquidity pool position reduces its NFTs in favor of ETH as people buy NFTs from the pool. For example, as a result of this volatility, your position may have 0.7 NFTs and 1.3 ETH in the end.
Let's say you deposit 1 ETH and 1 ETH worth of NFTs and the value of the deposited NFTs drop. Your liquidity pool position increases in NFTs and decreases in ETH as people sell their NFTs into the pool in exchange for ETH. For example, as a result of this volatility, your position may have 1.3 NFTs and 0.7 ETH in the end.
Note that your position is generating 1% of fees collected on each trade that passes through the pool. The more users that trade, the more yield you capture. This yield auto-compounds back into your position until you withdraw.
If the fees of your position generates > IL, congrats you are profitable!
If the fees of your position generates < IL, unfortunately you are not profitable.