Active & Inactive Liquidity

As an asset's price fluctuates, it may move beyond the price range set by liquidity providers (LPs) for a specific position. When this happens, the liquidity for that position becomes inactive, and the LP stops earning fees until the price reenters the range.

As the price shifts in one direction, LPs accumulate more of one asset as traders exchange for the other. This continues until the liquidity position consists entirely of one asset. However, unlike traditional models, concentrated liquidity ensures LPs rarely reach extremes (e.g., 0 or ∞) because of the ability to define precise price intervals. When the price reenters a defined range, the liquidity becomes active again, and LPs resume earning fees.

LPs have the freedom to create multiple positions, each with its own price range. This flexibility allows LPs to strategically distribute their liquidity across ranges, optimizing earnings while keeping their liquidity active as much as possible.

Concentrated liquidity not only gives LPs granular control over their positions but also lets the market naturally determine an efficient distribution of liquidity. Rational LPs are incentivized to focus their liquidity where it will remain active, maximizing returns and supporting a more efficient trading ecosystem.