In this article, I will share with you one of the most interesting issues for traders, investors, and exchanges in the current cryptocurrency market: liquidity.
What is liquidity? What factors affect liquidity? How to check the liquidity of a currency? All are answered in today's article.
Let’s get started with this article!
What is liquidity?
Liquidity, also known as liquidity, is the buying and selling of a cryptocurrency in large quantities with no (or little) impact on the price of that cryptocurrency.
Liquidity is not only used in the cryptocurrency market, but also for stocks or any trading asset. An asset is considered highly liquid when it can be sold quickly without a significant drop in price compared to expectations, such as BTC, ETH, etc.
What is Liquidity and Examples of Liquidity
Liquidity Example
For example, in real life, there is a very liquid asset, that is gold. You can buy and sell gold anywhere, not just in a gold shop. The reason why gold has high liquidity is because of its preciousness and high acceptance by people.
Another example is cash. If you notice, we “trade” money all the time every day, exchanging it for other things. Therefore, cash is an extremely liquid asset.
Some assets have poor liquidity or very poor liquidity, such as real estate, antiques, furniture, and artwork.
The nature of liquidity
As I said, the essence of liquidity is the trade-off between transaction speed and buying and selling prices.
With coins that have good liquidity, this trade-off will be very low. This means that when you buy quickly or sell in large quantities, the price of that token will not be affected much.
Conversely, for illiquid tokens, this trade-off will be higher.
Let me give you an example to help you understand:
You buy coin A at $1, the trading volume is $100,000, and after one month coin A is worth $10. At this point, you have made 10 times the profit, or $1 million.
However, the buy volume at $10 was very small at only $100,000, and the total volume in the price range of $10 to $9 was $1 million.
If you want to take profits immediately, you will have to trade 10% of your profit, selling at $9. In return, you will shorten the waiting time to sell all the A quantity almost instantly.
The importance of liquidity
Liquidity is always a very important issue that investors always consider very carefully before investing in any market. Especially in emerging markets such as cryptocurrencies, liquidity has always been a headache for many big money investors who want to enter the market.
Since liquidity affects price, there is a difference between the expected and actual returns of this cryptocurrency.
Suppose, you hold a large amount of token B and get a 30% profit. Now, you want to quickly sell the B token to get the 30% profit. But unfortunately, the liquidity of token B is very poor. If you accept the liquidity, you will lose about 50% of the value, that is, from the 30% profit, you will lose 35%.
If you want to sell but still keep 30% of the profit, it will take more time to sell at that price. However, the market is not just buying and selling brothers. If you don't sell, someone else will take over and make the price fall quickly.
Therefore, choosing a currency with high liquidity is always a safe choice for large capital investors.
3 Factors Affecting Liquidity
Project Popularity
This factor tells how much interest the community has in a coin. Usually, the more popular a currency is, the more people trade it.
For example, among the top 10 cryptocurrencies with the largest current market capitalization, 5/10 of them are also the top 10 cryptocurrencies with the largest 24-hour trading volume.
Community Hype
In fact, this factor also indicates that there is some interest among investors, but it sometimes appears in unpopular assets.
Let me give you an example: Before, no one knew about SHIB (Shiba’s token), but because of DOGE’s FOMO, SHIB was the next token that many people traded. Sometimes it even reached the top 10 coins with the largest daily trading volume.
Project Reputation
Not all reputable projects have high liquidity, but most of the time, reputable projects will also have ample liquidity.
This makes sense because if a project works seriously, the community will pay more attention to them.
How to check the liquidity of a currency
From the above examples, you also clearly understand that liquidity is a factor that has a great influence on trading decisions. Because it shows how easy it is to buy/sell, in and out of any token.
Therefore, before deciding to trade a certain coin, you need to check the liquidity of that coin by checking the following 3 factors:
24-hour trading volume.
Order book depth.
The difference between the buying and selling prices.
24-hour trading volume
Volume shows the liquidity of the market and data on past trading volumes. This is also information that can be used to predict future price behavior.
You can use Coinmarketcap, Coingecko or Coin98 Market to check the trading volume of the currency you want to trade in the last 24 hours.
Remember, this is total volume, so you have to see which coin has the most volume and if the exchange is in the middle of fake volume or fake trading. If you fall into this category, it will be hard for you to trade quickly because most of them are trading bots.
Order Book Depth
After choosing an exchange with real trading volume, you must check the order book depth of that coin exchange.
This helps estimate liquidity if a trade is made immediately in the desired volume.
For example: You want to sell 100,000 VND A at 0.1 USD, and the order book depth for buying coin A shows:
At $0.10, there are only $40,000 of Aces.
$0.09 and 60,000 A.
From there, if you weigh transaction speed and liquidity, you can estimate the difference.
Bid-ask spread
The Bid-Ask Spread represents the difference between the latest buy and sell orders shown in the order book. If the bid-ask spread is high, the liquidity of the token is low and vice versa.
Example: This is the buy and sell price of DOGE/PAX coins on Binance exchange. You can see that the most recent buy order for DOGE is 0.0025293 PAX and the most recent sell order is 0.0026798 PAX.
Therefore, if you execute a buy order for DOGE, you will buy at a price of 0.0026798 PAX and can only sell at a price of 0.0025293 PAX. Therefore, you lose about 6%.
What are liquidity pools and liquidity mining?
These are new concepts unique to Crypto, which began around the time DeFi was born in late 2020.
Liquidity Pool refers to the liquidity "pool" of AMM exchanges or lending projects, where users deposit assets as liquidity for others to trade. In order to encourage users to deposit assets, the project will have incentives, such as deducting part of the transaction fees for them, giving users who provide liquidity more project tokens, etc.
This action is called liquidity mining, or an incentive program for providing liquidity. The purpose of liquidity mining is to attract more liquidity to the AMM so that large transactions do not slip too much; or in the case of lending projects, to encourage users to participate in lending.
Should you invest in highly liquid or less liquid currencies?
If the amount of money invested is large, it is best to choose a project with high liquidity because it will not deviate too much. Imagine that you bought an order that makes the asset price rise by nearly 5%, then there is a great risk of being liquidated in large quantities.
But suppose you see a project with potential but low liquidity, what should you do? There are two ways to solve this problem:
Divide large orders into many small orders, watch the currency price while buying, and decide whether to buy continuously or buy a little bit, and then buy more when the price drops.
Choose a DEX with high liquidity, such as SushiSwap, Uniswap, etc.
Summary
In any market, liquidity is always an extremely important factor. Without good liquidity, it will be difficult for the market to develop.
Back to the current cryptocurrency market, liquidity is still an important issue that prevents many traditional investors from jumping into this potential market. Going a little deeper, you will find that many coins currently do not have good liquidity, even though the expected profit margins can be high.
Hopefully, after reading this article, newbies to the market will not make the mistake of choosing coins with poor liquidity to trade.