What Is Liquidity in Trading and Why Does It Matter?
Trading Analysis

What Is Liquidity in Trading and Why Does It Matter?

1 year ago

Market liquidity is something novice investors and traders tend to ignore while buying a crypto asset. Learn how to monitor liquidity to buy an asset at a fair price!

What Is Liquidity in Trading and Why Does It Matter?

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Market liquidity is a crucial piece of the trading puzzle. It impacts everything from the bid-ask spread to trade execution – and yet many people have a limited understanding of it. Read on to learn everything you need to know about liquidity, and why it matters!
After hearing her boyfriend Sam talk about crypto for months on end, Caroline finally gives in and creates an account on a small crypto exchange with low volume. She decides to buy some ADA at the market price mentioned by the exchange. She buys them immediately, and later on, realizes that she bought the coins at a way higher price than she should have. She calls her boyfriend, asking how this happened, and if she can get her money back.

Sam tries to calm Caroline down and sends her this article to explain what went wrong. Let’s dive into what liquidity is, and discuss why it is so important to pay attention to it when you are trading.

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What Is Liquidity?

Liquidity is used to describe how easily you can buy or sell a certain asset, without impacting its price. In other words, it shows the buying and selling interest in a market, and how easy it is for transactions to take place. With more liquidity, you can buy or sell larger amounts of crypto without moving the market.

Markets with many participants and high levels of trading activity are generally more liquid – as there is a high supply and demand for that asset. With fewer participants and little trading activity, liquidity dries up fast. The more liquid an asset is, the easier it is to trade back and forth between the asset and fiat.

Liquid assets are the ones with high volumes, where large players easily get in and out of positions. The key here is speed because, in liquid markets, there is always someone willing to buy or sell your asset. Illiquid assets, on the other hand, trade with low volumes, and even players with moderate-size accounts struggle to fill or exit a position.

Forex markets are known for their high liquidity, especially when it comes to pairings between the major currencies, such as the US Dollar, British Pound, Chinese Yuan and Euro. Cryptocurrencies with lower market caps tend to have low liquidity, especially when it comes to pairings with fiat currency. This is what caused the problem Caroline ran into; the market was not sufficiently liquid to fill her market buy at a reasonable price.

Why Is Liquidity Important?

Caroline's fictional example shows the importance of liquidity. Without ample liquidity, it’s very difficult to buy or sell assets at a favorable price. For example, let’s say you are looking to buy a first-edition Charizard Pokémon card in perfect condition. There are very few people willing to sell such an object, let alone at a reasonable price. This is a perfect example of an illiquid market. Alternatively, let’s say you own an antiquity appraised at $75,000 – but there are no buyers willing to pay anything over $35,000. This again shows a lack of liquidity in the market.

In either scenario, it is very difficult to acquire or let go of an object at a fair price, and transactions will, therefore, take a lot of money and time to complete. This makes liquidity crucial for trading – as you need to be able to get in and out of positions at a moment’s notice, without spending a fortune on fees. This is another great advantage of high liquidity - it results in a relatively low cost of doing business.

How Is Liquidity Measured?

Most traders measure liquidity by the bid-ask spread: the gap between the highest bid and lowest ask in the order book.

As a refresher, an order book is a database that gathers all the available liquidity and displays it in a simple manner. It shows buy and sell orders, giving traders an insight into the available liquidity, demand and supply. Most older books sort orders by price level and the size of the available liquidity.

In other words, it’s the difference between the price at which someone is willing to let go of an asset and the maximum price buyers are willing to pay for that asset.

When the spread is tight, it indicates the market is highly liquid – whereas a wide spread indicates an illiquid market. In the past, traders used to look to trading volume as an indicator of liquidity, but recent years have shown us that high volume does not necessarily constitute high liquidity. The stock market crash of 2008 and the pandemic-related crash in 2020 are just two examples, where the market crashed with high volumes, but very low liquidity.

What Is Liquidity Risk?

The liquidity in a market can change quickly. As we previously mentioned, the liquidity in the stock market dried up rather quickly in the stock market crash of 2008, and again in the pandemic-induced crash of 2020. Situations like these can cause serious problems, as investors are suddenly unable to exit a position.

The chances of the occurrence of such events are called liquidity risk – something seasoned traders and investors always take into account in their process.

Liquidity risk happens in all markets but is most prevalent in real estate markets. The real estate market is already less liquid than most other markets, but when interest rates skyrocket, many people are unable to cover their mortgage payments – resulting in significant selling pressure being added to the market. This phenomenon has triggered multiple housing market crashes, simply because there is insufficient buying interest to withstand the new selling pressure.

How To Use Liquidity in Trading?

As discussed, liquidity is a crucial factor to consider when entering or exiting trades. For example, during high volatility, it can be difficult to exit larger positions. Traders should be prepared for this – for example by using market orders or stop market orders. This type of order makes sure the trade fulfills even at a less-than-ideal price.

Another way of using liquidity in trading is to look for areas on the chart where liquidity is expected to be. In other words, where on the chart we can reasonably expect increased buying or selling interest. Especially when the market liquidity is limited, larger players must push prices into those areas in order to get in or out of their positions.

For this reason, you’ll often see the price move to where liquidity is expected to be – around key highs and lows. This is also where most people place their stop losses or look to enter breakout trades.

The chart below is a good example as the market pushed above previous highs, triggering both the stop losses of shorts (buy orders) and breakout traders (buy orders). These buy orders allow the large players to sell into those orders – before the price falls back down.
This liquidity engineering behavior in the market is called a Swing Failure Pattern.

Closing Thoughts

All in all, liquidity is widely considered to be a crucial element in trading – overlooked by many beginner traders. Without sufficient liquidity, traders either get stuck in positions or end up paying a big premium to market prices.

Liquidity has far-reaching effects on the market, so much so that the market tends to move to the areas where liquidity is expected to be better.

It is recommended to pay attention to the bid-ask spread before entering or exiting a trade. Just having a quick glance at the order book before taking a trade can save you hundreds (if not thousands) of dollars!

Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form. Please do your own research.

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