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 markets and liquid assets.
A liquid market is a market that has a lot of trading activity, with many individuals willing to trade. On the other hand, 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. So, 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 at the price he wants. Bob’s trade doesn't affect the market price as there is sufficient liquidity to accommodate it.
However, if Bob is asking to sell his 5 tokens at the current market price but the market is illiquid or has low liquidity, he is required to lower his asking price or wait for the market to become more liquid. This is due to the lack of buyers willing to pay the price Bob is asking. And 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
There are three important indicators that can help determine if a market is liquid or illiquid: 24-hour trading volume, order book depth, and the bid-ask spread. the bid-ask spread is the difference between the lowest ask price and the highest bid price.
However, the order book might not always be an accurate representation due to factors like stop-limit orders and iceberg orders, which are not always visible in the order book.
Liquidity is extremely important when considering your trades. It is one key factor for easily entering or exiting a particular market.
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