Liquidity as a term is defined as the ability to buy or sell assets in the market without causing a drastic change in the assets price.
Liquidity can refer to two different areas; liquid market and liquid asset.
Liquid market means that there are always investors in the market willing to trade. A liquid asset refers to an asset that can be easily converted into cash.
But what does this mean when talking about cryptocurrencies?
As with any investment, you want to be able to sell and buy tokens quickly without a need to cut the price or wait for too long for the trade to be matched. In order for this to be possible, the market you’re trading in must be liquid. In other words, there must be high trading activity and the bid and ask prices must not be spread too far apart.
Let's take an example from a seller’s point of view;
Bob has 5 tokens of a certain cryptocurrency and the price for his tokens has increased in the past few days. Bob is happy and decides to quickly sell all his tokens for the current market price.
If the market is liquid, meaning that there are enough buyers that are willing to buy Bob’s tokens for the price he is asking, Bob is able to sell his assets quickly and sell at the price he wants. Bob’s trade does not affect the token price since there is sufficient liquidity to accommodate for Bob’s trade.
However, if Bob is asking to sell his 5 tokens at the current market price and the market is illiquid or has low liquidity, meaning that there are not enough buyers willing to pay the price Bob is asking, he is required to lower his asking price or wait for the market to become more liquid to be able to sell his tokens. If Bob decides to sell at a lower price, his trade is also affecting the current market price of the token.
How to tell if a market is liquid
When looking to see if a market is liquid or illiquid, it’s good practice to look at three important indicators. 24 hour trading volume, Order book depth and the amount by which the ask price exceeds the bid price, also known as the bid/ask spread.
However, the order book might not always be an accurate representation due to factors like stop-limit orders and iceberg orders, which are created with using trade automation and as a result don’t always appear on an order book until specific conditions are met for those orders.
Liquidity is extremely important when considering your trades. It is one key factor for easily entering or exiting the market.
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