A liquidity pool (LP) is nothing more than a "pool of money" which allows people to trade two assets. In the example below, the LP contains ETH and $REN, meaning any liquidity provider puts in equal amounts of $REN and ETH and the pool starts with a 50:50 ratio of ETH to $REN. When the market buys $REN this shifts the balance as there is now more ETH in the pool, increasing the price of $REN.
A liquidity pool that contains:
- $1000.00 worth of $REN and
- $1000.00 worth of ETH
If someone buys $500.00 worth of $REN, the balance would shift to a 75:25 ratio and increases the price of $REN by a large margin. The larger this pool, the more stable price pairing of $REN/ETH.
Any trade on the LP is accompanied by a small fee (1% at the time of writing for $REN) which is distributed across the liquidity providers based on their share in the liquidity pool. Since this is true for each transaction these fees can accumulate quite significant sums making it an interesting investment opportunity.
One last thing to note is that any assets put into the pool can be taken out at any point and get back the same amount that was put in (although the asset distribution might be different).
As with every monetary investment, there is an associated risk. Providing liquidity may have an impermanent loss, meaning the difference in the dollar value of your assets.
$2000.00 worth of ETH and $REN is provided to the pool, but when this position is closed the price of $REN is a lot higher than when the assets were put in the pool (meaning people bought more $REN). This means more ETH will be returned to the owner (in terms of dollar value) then $REN. I.e. no profit was made from the price increase in $REN since the distribution of assets shifts to the more stable asset of the two.
This is dependent on volume and the range specified, but about 0.5% to 1% per day can be expected. This can increase with a smaller range.