Liquidity: why it is important in trading
March 21, 2023
Providing financial liquidity is one of the main services of financial intermediaries such as brokers and exchanges.
In this article, we will explore the definition of liquidity for assets and markets, and why it is important in cryptocurrency trading.
What is liquidity? The financial definition
The definition of liquidity depends on the context in which it is used: the everyday use of this term, mostly by journalists, refers to the availability of cash in circulation or in reserves.
In economics textbooks, however, you will see it described as the ease with which you can convert an asset into fiat money without affecting your capital. That is why we speak of liquid or illiquid assets: there are instruments that are easily converted into money, others that require more complex procedures and transaction costs. Think, for example, of how readily you can sell a company share versus a real estate property.
In the practice of trading, “liquidity” is also often used to describe a specific market.
The main indicator used to calculate the financial liquidity of an asset or market is the trading volume. The reason is simple: the easier it is to convert an asset, the more frequently it will be traded. So, in our example, the real estate market will have very low daily volumes, indicating that it is not very liquid; the stock market on the other hand changes every minute due to its liquidity.
However, there are other elements that influence liquidity: let’s look at how this works in the specific case of the crypto market.
What are liquid assets? The case of cryptocurrency
Are cryptocurrencies liquid assets? Even to define the financial liquidity of a single asset, we have to distinguish between the two facets of the term.
Regarding the ease of conversion, cryptocurrencies have several strengths and weaknesses. Technically, the process required to convert them today is very simple thanks to exchanges, however, the market is not as large as that for financial instruments.
Usually, to calculate the liquidity of a cryptocurrency, you can look at its volume in 24 hours and the market cap, which indicates the size of the market. To consult this data, it is not necessary to access an exchange, just visit market data aggregator sites such as CoinGeko.
Liquidity is not a fixed characteristic of an asset or market, but changes in response to market cycles or market movers. The changes in supply and demand that these events bring about therefore affect liquidity, as they bring or drain volumes in the markets.
Think, for example, of a sudden increase in interest in a particular cryptocurrency: many new traders enter the market and consequently more liquidity is channelled to the market and exchanges.
In the opposite situation, however, if for some reason there is a sudden drop in interest, many traders will exit the market by liquidating their positions.
The advantages of a liquid cryptocurrency are several: compared to an illiquid one, it will be less manipulable, less volatile, and provide more data for traders and analysts to understand the trend.
This is one of the reasons why it is difficult to strip the top cryptos of their dominance: the more they are traded, the easier it is to trade them.
The other definition of liquidity is the availability of cash: in this sense, we enter the realm of tokenomics. Specifically, in the cryptocurrency market, very often the availability (circulating and total) is predetermined, the supply therefore may have a maximum limit.
Why is liquidity important when trading?
When you trade on crypto exchanges, you can deduce market liquidity from several instruments.
By selecting a pair, on advanced exchanges you will be able to consult:
- The volume over 24h – As in the analysis of a cryptocurrency in the context of the aggregated market, the volume over the previous 24h on a single exchange can also be very useful. It gives you an idea of the liquidity in circulation and current interest.
- The bid-ask spread – this is the difference between bid and ask, visible in the order book. The lower this number is, the more liquidity there is in that market
- The depth chart – it’s the most complete and immediate representation of liquidity and where it is. In particular, it indicates the market depth, i.e. the market’s ability to absorb many large orders without experiencing volatility. The larger the areas delimited by the lines on the chart, the greater the depth and therefore the more liquid the market.
But what does it actually mean for traders when a market is illiquid? First of all, the large discrepancy between supply and demand generates high volatility, and thus more risk for traders, who will find it difficult to predict the crypto’s performance in the short term.
Specifically, there are two concrete risks one can incur if a market experiences illiquidity phases:
- Slippage, i.e. the execution of an order at a price other than the set price
- The delay or non-execution of orders
These two events occur when there is no liquidity for certain prices, i.e. supply or demand is not met by a buyer or seller.
In the crypto market, these situations are very common among low-capitalisation and newborn cryptocurrencies, or on decentralised exchanges (DEX).
However, low liquidity does not necessarily exclude trading. Indeed, there are different strategies and approaches to this activity.
High liquidity is crucial if your strategy requires a relatively lower level of risk, if it is based on prompt reaction and thus fast execution of orders, and on high-volume transactions.
Some professional traders, on the other hand, are willing to take more risks in an attempt to make large profits in a short time. To trade in low liquidity conditions, however, it is necessary to know exactly how to take advantage of high volatility and having to deal with slippage.
Every market has its own characteristics; there is no perfect market that can meet the needs and requirements of every single type of investor. Knowing your objectives and risk profile, you can choose the market and the definition of liquidity that best suits your needs.