The term liquidity is defined as the ability to buy or sell assets in the market without causing a drastic change in the price of the assets.
The term liquidity can refer to two different areas: we speak of market liquidity and liquidity of an asset.
The liquidity of a market refers to the fact that there are always investors on this market willing to carry out trading transactions. The liquidity of an asset refers to the fact that it can easily be converted into cash—also called cash.
What does it mean when we talk about cryptocurrencies?
As with any investment, you want to be able to sell and buy tokens quickly without the need to fluctuate in price or wait too long to find a matching order. For this to be possible, the market you are trading on must be liquid. In other words, there must be intense trading activity and the bid/ask prices must not be too far apart in value.
Let's take an example from the seller's perspective;
Bob has 5 tokens of a certain cryptocurrency and the price of his tokens has increased in recent days. Bob is satisfied and decides to quickly sell all his tokens at the market price.
If the market is liquid, meaning there are enough buyers willing to buy Bob's tokens at the price he asks, he is able to sell his assets quickly and at the price he desires. Bob's trades do not affect the price of the tokens because there is sufficient liquidity to execute his market order.
However, if Bob asks to sell his 5 tokens at the current market price and the market is illiquid or has little liquidity, meaning there are not enough buyers willing to pay the price Bob asks Bob, he has to lower the asking price. or wait for the market to become more liquid to be able to sell your tokens. If Bob decides to sell at a lower price, his trade also affects the current market price of the token.
How to determine if a market is liquid
To determine whether a market is liquid or illiquid, it is recommended to look at three important indicators: 24-hour trading volume, order book depth, and the difference between the bid price (sales) per relative to the ask (buy) price within that book—also called the bid/ask spread.
However, the order book may not always be an accurate representation of market liquidity, due to factors such as "stop-limit" orders and so-called "iceberg" orders, created using the transaction automation. These orders do not systematically appear in the order book, sometimes waiting for certain conditions to be met before being put into place.
Liquidity is an extremely important characteristic when considering trading. It is a key factor in determining whether you can easily enter or exit the market.
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