Trading Education

Liquidity Explanation

Many of us have heard about the concept of "liquidity" and, in general terms, imagine what lies behind it. However, it is quite difficult to tell in a few words what it is. It is even more difficult to explain in plain language how to calculate the current liquidity. Today, in the article, we will deal with these concepts, as well as measure the liquidity, allowing us to judge the current state of any project.

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First things first

Liquidity is the ability to quickly convert assets into their monetary equivalent at good prices. There are high and low-liquid values, as well as illiquid assets. The concept of liquidity can be applied to any firm, securities, real estate, vehicles, and various property owned by an enterprise or an individual. Usually, the money that circulates in a given economic system has the highest liquidity. The same principle in the cryptocurrency industry, where it can be identified as the ability to buy/sell cryptocurrency without causing serious fluctuations in its rate. For example, one market participant can sell 100 BTC and not affect the bitcoin price in any way. Not only cryptocurrency can be liquid, but the market itself. A liquid cryptocurrency is considered only if it can be exchanged for fiat without any problems and consequences. The market is liquid only if its participants are ready to trade. That is, there is a huge trading volume on the market of a particular cryptocurrency, and the supply and demand prices do not differ much, then this is considered as liquidity.

Why is it important?

The increased focus on liquidity underscores its importance to financial markets. After all, the more liquid the market is, the more stable it is. When buying or selling Bitcoin, on the other hand, there are always many traders ready to execute an order with minimal impact on the asset price. However, a less liquid, more obscure altcoin is likely to influence its price as a result of a major transaction.

To execute a large trade, you will probably have to go through the order book, eventually increasing the supply and demand spread and raising or lowering the overall price of the asset. In this case, not only the trader experiences strong slippage, but the asset itself becomes more volatile over time. A more liquid asset is more stable both in individual transactions and in the market as a whole.

How to measure?

  • Trading volume. Volume refers to the number of coins sold in one market over a while. It can indicate the direction and movement of the current market trend. An increase in trading volume means more trading activity (selling and buying) and is therefore a liquid market. In addition, higher volume supporting a market trend means higher market activity supporting the overall trend. However, if price movements are not supported by volume, this would mean that only a small number of people are supporting the current price trend and therefore may be short-lived. In fact, price spikes on low trading volumes can be an indicator of price manipulation.
  • Bid-ask spread. Any cryptocurrency exchange has an order book that displays all buy-orders (created by buyers) and sell-orders (created by sellers). The order book is an excellent indicator of liquidity as you can assess whether the pair of coins you are interested in is liquid or not. You can estimate the spread between the buy and sell prices by looking at the order book. You can calculate the spread between the bid and ask price by taking the difference between the lowest bid price (sell order) and the highest bid price (buy order). The most liquid assets have the smallest bid and ask spread, while in less liquid markets the difference between the bid and ask prices tends to be much wider.

The risks & potential benefits of low-liquidity

Lower liquidity leads to less stable asset prices, which means that slippage and price manipulation are risks in a low liquidity environment, but also price drops can be turned into sudden disruptions. The absence of market participants can lead to long waiting times, which, especially during market fluctuations, can be detrimental to the trader.

On the other hand, this lack of stability can be beneficial to the trader. When a large order lowers the price due to low liquidity, an arbitrage opportunity to buy an asset at a discount opens.

In general, the most important thing is to understand exactly how liquidity affects your trading and to develop a coherent strategy that takes these factors into account, deliberately choosing assets and exchanges with the right liquidity environment.
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