Understand how liquidity can be more important than price alone.
Liquidity is a driving force in the cryptocurrency and traditional markets, which even a casual trader shouldn’t ignore. Gain a better understanding of how particular market conditions can result in high volatility and affect your trades. It’s time to find out why liquidity is vital in any healthy market by getting the hang of high and low liquidity indicators.
What is Liquidity?
Liquidity measures how easy it is to exchange a cryptocurrency into another asset, cryptocurrency, or fiat currency. When dealing with investment, be it a cryptocurrency or something else, if it’s easy to exchange for other valuable assets, you can consider it liquid or say it has high liquidity. If it’s impossible to convert, it would be illiquid or have low liquidity.
What Effect does High Liquidity Have on Crypto?
Highly liquid cryptocurrencies are easy to trade, have tight spreads (close price between the buy and sell-side of an order book), and are typically easy to find on numerous exchanges and marketplaces. Bitcoin is the best example of a cryptocurrency with high liquidity.
When a cryptocurrency has good liquidity, it should be easy to exchange, and filling buy and sell orders close to market price should be no issue. Therefore, high liquidity cryptocurrencies are most suitable for traders and signify that the asset is actively traded. While high levels of liquidity can drop off and are never guaranteed, long periods of good liquidity can be seen as a sign of a trade with a lower risk than low liquidity alternatives. However, when it comes to cryptocurrency, you should always consider these higher-risk investments, so this should be taken into consideration as it is very much relative.
Signs of a High Liquidity Crypto
- Low price spreads between bids and asks on order-book exchanges
- High trading volume, especially on the daily timeframe
- Large trades don’t move the market noticeably or at least not significantly
What Effect can Low Liquidity Have on Crypto?
If you’ve seen a token or coin do 10,000% in a single day, low liquidity can result in these volatile price swings. If there is minimal trading activity for an asset, this can result in highly volatile price swings. When trading some cryptocurrencies with low activity levels, even trades around $1000 can result in massive price changes. The problem is that exiting crypto with low liquidity can be challenging or result in receiving significantly lower than the market rate when closing out a trade.
Often spreads between bid and ask (buy and sell) can be extremely high, meaning that even if you put through a buy order and sold it minutes later, you’d be taking a loss. Low liquidity assets are not only challenging to trade but can be very costly as well. However, if you have confidence that an asset will improve over time in terms of both price appreciation and trading activity, it can still be a worthwhile investment; it’s just one you should consider high risk.
Signs of a Low Liquidity Crypto
- High spreads between bids and asks orders on large order-book exchanges
- Low trading volume, especially on the daily timeframe
- Small trades can move the market price noticeably or even significantly
Is Crypto Less Liquid than Other Asset Types
While once crypto was far less liquid and a considerably smaller niche than it is today and essentially considered very experimental, times are changing. Cryptocurrency has become a much larger industry with market liquidity that is growing by the day. However, there are far more liquid assets out there. A prime example is cash, at least in countries with relatively stable economies.
It’s also worth noting that while some markets are massive in scale, with billions of dollars worth of value being exchanged regularly, it doesn’t necessarily mean you can quickly get in and out of them. An excellent example of this problem would be real estate and other tangible assets, the problem being in their phyiscal properties. Even when the real estate is booming, it doesn’t mean you could quickly go out and sell your house on the same day, and even if you did, it would be considered quite a rare occurrence. Precious metals are another massive market but arguably can struggle from liquidity issues in some ways. Just because you can paper trade gold in just a few minutes doesn’t mean you could find a quick exchange for physical gold for a fair market rate.
Liquidity can often be relative, so the best way to gauge it is to look at similar assets and compare them. For example, look at how easy buying or selling them is. If other investments with similar properties are comparable, as when looking at liquidity, sometimes the surrounding assets help to provide a much clearer picture.
Why is Liquidity Important?
While it’s easy to assume that price is the only metric that matters, things are never quite that simple. It doesn’t matter if something is worth a million dollars if there’s no one willing to buy it from you. Understanding whether something is liquid can help you better understand market conditions surrounding specific cryptocurrencies and enable you to make better decisions when it comes to trading.
The next time you see a sudden price movement, consider all the information you have at your disposal before jumping right in, and you may just find your trading benefits from the added attention to detail.