[vc_row][vc_column][vc_column_text]In this article I will explain what is liquidity in financial markets. First we will look at the definition of this technical term, accompanied by a concrete example. Then we will look at liquidity in the traditional market and finally in the cryptocurrency market. We will conclude with the tools that exist to assess liquidity.
It is a key concept in financial markets that describes the ability of an asset/security to be quickly bought or sold in the market at a price that reflects its intrinsic value. In other words: the ease of converting it into cash.
High liquidity will be defined as high when the level of trading activity is significant, i.e. when supply and demand are high. Why? Because in these conditions it is easier to find a buyer or a seller. When there are a small number of participants on a market and transactions are not frequent, we will talk about an illiquid market.
Let’s take a concrete example: Tom wants to sell 5 tokens of a cryptocurrency X. He goes to his favorite trading platform and initiates a market sale. What’s going to happen?
- If the X market is very liquid, Bitcoin for example, well Tom will be able to quickly sell his 5 tokens at the current price. Its sale will not have a real impact on the market because supply and demand are high.
- If the X marketis not very liquid, for example RLC, well Tom will not be able to sell at market price. He will be obliged to lower part of his sale order. Why? Because quite simply no one will be able to buy 5 tokens from him at the price he asks for. He may be able to sell 1 token at market price and then he will have to contact buyers who are willing to get his tokens for a lower price. And as a result, its sale will have an impact on the market.
So when trading in a financial market, liquidity must be taken into account before you even open your position! A lack of liquidity means increased risk. Indeed, if the volatility is high in the market and there is a lack of liquidity, you are more likely to have difficulty closing your position at a desired price, and this can result in a significant lag between the determined exit price and the actual exit price.
The most liquid traditional markets are as follows:
- Forex: considered the most liquid market in the world, due to the huge volumes and frequency of trades.
- Shares of large-capitalization companies.
- Commodity market: in particular through futures contracts.
Liquidity of the cryptomarket
Currently in this maket, only Bitcoin and Ethereum have significant liquidity. This is linked in particular to their capitalisation and their respective trading volumes in the last 24 hours. Then there are the “large” Altcoins, which have quite acceptable liquidity. And finally, small Altcoins where the volume traded in the last 24 hours is for example less than 10 BTC.
At 4C-trading, we never issue calls on Altcoins with less than 400 BTC in volume traded over 24 hours. The reason? Because otherwise we would have a liquidity problem. Indeed, making a call on an illiquid cryptocurrency would not be a good idea. First, very quickly the price would increase (in the case of a long call), so we would leave the buying range too quickly and therefore not all our customers would be able to enter the position. Then, this kind of technique: increasing the price of an Altcoin very quickly through a massive injection of capital is simply a “Pump & Dump” and it is in no way something that 4C-trading wants to be associated with. Finally, problem number 1 comes back but this time to sell his position. That’s why the more capital you have, the more attention you need to pay to liquidity in the market.
Let’s now look at the tools that exist to detect whether a market is liquid or not
The first tool, as detailed above, is the trading volume. Then there is the orderbook, an electronic list of buy and sell orders for a security, organized by price level. An empty orderbook is an order book where the volume of buyers/sellers is low. But be careful in your analysis of the orderbook because in buy/sell orders there are also stop-limits of current positions and this can bias your analysis. Finally, you can look at the bid-ask spread. The latter indicates the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept.
Hope you learned something new.
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