Liquidity is a term defined as the ability to buy or sell assets in the market without causing a large change in the price of the asset.

Liquidity can be used in two different areas; Liquid markets and liquid assets.

A liquid market means there are always investors ready to trade in the market. A liquid asset is an account that can be easily converted into cash.

But what does it mean for cryptocurrency?

As with any other investment, you want to be able to buy and sell tokens quickly without having to reduce prices or spend time waiting for transactions to be matched. To be able to do this, the market you are trading in must be liquid. In other words, the market must have a lot of trading activity and the difference between the bid and ask prices is not too large.

Consider the following example from the seller's perspective;

Bob has 5 tokens of a cryptocurrency and the price of these tokens has increased over the past few days. Bob is happy and decides to sell all his tokens at the current market price.

If the market is liquid, meaning there are enough buyers willing to buy Bob's tokens at the price he desires, then Bob can quickly sell his assets and sell at the price he wants. Bob's transaction does not affect the token price because the market is liquid enough to carry out Bob's transaction.

However, if Bob asks to sell his 5 tokens at the current market price and the market is illiquid or has low liquidity, it means there are not enough buyers willing to buy Bob's tokens at the price that he wishes, he is forced to lower the selling price or wait until the market is more liquid to be able to sell his tokens. If Bob decides to reduce the price, his transaction also affects the current market price of the token.

How to know if the market is liquid or not

When assessing whether a market is liquid or illiquid, three important metrics should be looked at. 24-hour trading volume, order book depth, and the spread between bid and ask prices, also known as the bid/ask gap.

However, the order book does not always accurately reflect factors such as stop-limit and iceberg orders, which are created using automated trading and are therefore only appear on the order book when specific conditions for those orders are met.

Liquidity is extremely important when considering your trades. That is one of the main factors to easily enter or exit the market.

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