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Why Liquidity is a Key Aspect of Trading

June 22, 2021
7 min
Why Liquidity is a Key Aspect of Trading
Beginner
You will learn

    Very often we hear about liquidity in reference to financial markets and the monetary policies of central banks around the world. Financial intermediaries, among their many activities, aim to provide the market with numerous services with which to satisfy individuals and businesses in various financial needs. One of these services is to offer high liquidity.

    In the cryptocurrency market, liquidity works slightly differently than in traditional financial markets, due to its inherent characteristics. In this article we will analyse the concept of liquidity, its effects on trading and useful applications.

    What is Liquidity?

    There are two definitions of liquidity in traditional finance with meanings that fit the specific situation:

    Liquidity

    Liquidity is a parameter that indicates the ease with which it is possible to convert a cryptocurrency into bank money without affecting the price of the former. Liquidity is a parameter that identifies the ease with which a cryptocurrency can be exchanged through an exchange for a traditional FIAT currency without being affected by the price of the former. slittamento di prezzo

    Thus, the definition of liquidity has a double meaning, which depends mainly on the context under consideration.

    Assets and Markets

    Liquidity can be associated with a market or an asset. Using an example, in the large Forex market it is possible to trade the currencies of every country in the world, this is one of the markets with the highest liquidity.

    Fun Fact

    The Forex market had an average daily peak trading volume of $6.6bn in 2019 according to Bank of International Settlements.

    With such a high daily volume, it is extremely difficult to observe price slippage during trading. This is possible because due to the high liquidity, both buyers and sellers will always find a counterparty who will be happy with the buy and sell price respectively.

    Slippage

    This is the difference between the execution price of an order and the price entered when placing the order. It occurs when the market suddenly moves in the opposite direction of the order as the exchange is preparing to execute it, but the original price is no longer available.

    Liquid assets, on the other hand, are all those assets that are easily and quickly convertible into large quantities. The most common liquid assets are shares, government bonds and open-ended mutual funds.

    An Asset’s Liquidity

    As in any free market, there are two main factors influencing the liquidity of an asset: supply and demand.

    In particular, in the cryptocurrency market, very often the supply (circulating and total) is predetermined. Demand, on the other hand, can change very abruptly for a variety of reasons, and consequently, the latter can have a considerable impact also on liquidity.

    Think, for example, of the sudden increase of interest in a particular cryptocurrency: many new traders will enter the market and consequently more liquidity is channelled towards the market and towards the Exchanges.

    In the opposite situation, instead, if for some reason there is a sudden contraction of the interest, many traders will exit from the market draining the liquidity outside of the same and consequently from the Exchange.

    Attention must also be paid to favourable regulations and acceptance by state legislators, as this generally attracts further liquidity. Historically we have seen that if a country takes hostile or favourable measures towards Bitcoin, for example, this will have a consequence on the market.

    Bitcoin vs Altcoins

    Bitcoin, the first cryptocurrency to be created and the most popular and traded, currently holds the record for volume, liquidity and market capitalisation.

    The numerous altcoins that have emerged since then have caught up considerably over the years, however their capitalisation and liquidity remains far less than that of Bitcoin.

    There are some objectively problematic situations for traders who would like to trade the lower capitalisation altcoins due to their higher volatility and growth potential.

    This phenomenon is accentuated on decentralised exchanges (referred to as DEX) where high slippage conditions or high execution fees are often encountered.

    It can be said that Bitcoin and Altcoins are suited in different and complementary ways to the different objectives of traders in this sector.

    A Market’s Liquidity

    How to tell if an Exchange is liquid

    Determining the generic liquidity of the asset before choosing it is important, but in practical trading, it is the platform you use that makes the difference.

    There are some readily available data that, when analysed correctly, allow us to understand the level of liquidity that characterises the market of a specific Exchange. It is therefore very useful to look at the following data:

    • The daily trading volume
    • The price slippage
    • The order book

    Why is liquidity important when trading?

    Centralised exchanges match the supply and demand for a given cryptocurrency in a similar way to brokers operating in classic markets. Liquidity, therefore, plays a very important role for exchanges, given the structure of the market in which they operate.

    We’ve seen some of the key elements to look out for in order to understand if you are in a liquid market, but why is this an important aspect to consider?

    In illiquid markets, traders may find it difficult to enter/exit their positions, see their limit orders not executed, or face high slippage. All these elements, in different ways, certainly have an impact on the setting up of any trading strategy; this applies whether it is a standard operation (manual execution of orders) or an automated one with the help of Bots and trading systems.

    Liquidity or Illiquidity?

    Having seen the liquidity characteristics of exchanges and assets, we need to know that there are many traders with very different operating strategies and objectives.

    • High liquidity: it can be seen as an essential element for operations by institutional or traders or whales, for example, who trade large amounts of currency. This is because it allows them to react promptly in all those situations where speed and low slippage are key requirements for their investment strategy.
    • Low liquidity: other traders prefer to deal with low liquidity as long as they don’t have to give up on risky nascent markets or cryptocurrencies that could bring high returns at the same time. In this case, the low liquidity is taken into account in the trading strategy so that the risk is lower than the expected return.

    Conclusion

    Each market has its own characteristics and typical elements. There is no perfect market that can meet the needs and requirements of every single type of investor, rather there are many markets and each of them can provide the ideal conditions for the trader to operate. Once you understand your trading strategy, you are able to consciously choose the most suitable market.

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