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DeFi protocols thrive on liquidity and have created economic incentives for anyone willing to add liquidity to their platform. In return, protocols often provide you with Liquidity Provider (LP) tokens that represent partial ownership of that pool. The value of LP tokens depends on three main variables: price increase of the tokens in the pool, temporary loss, fees earned, and distribution by the pool to LP token holders. In this article, we break down the factors that affect profitability, examine the trade-offs, and learn about the diverse risk-reward profiles.
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