Why liquidity is critical for successful trading

Key Ideas When we talk about the movement of capital in financial markets, one term keeps appearing – liquidity. This is the measure that shows how quickly and without significant cost we can convert a digital asset back into cash or another active instrument. Imagine you have an incredible rarity in your suitcase, but you are stranded on a deserted island. Until you find someone willing to buy it at a fair price, the value remains invisible. In contrast, when you want to purchase Bitcoin for 100 US dollars through the BTC/USDT pair on one of the major cryptocurrency platforms, the operation is completed in seconds, with no visible impact on the market price. This is why understanding liquidity is inseparable from the success of the modern trader.

How is the health status of the market evaluated?

Starting from the analysis of trading volume, studying price fluctuations or examining various charting tools, we can gain a certain insight into the dynamics of a market. However, none of these indicators provide the complete picture without considering one defining factor – the level of liquidity in a given market. When there is insufficient liquidity in the market, any significant position transfer can cause price deviations that cannot be predicted. This article exposes the nature of liquidity and demonstrates its fundamental role in the crypto ecosystem.

Definition and Characteristics of Liquidity

By liquidity, we understand the ability of an asset to be converted into an alternative asset without significantly affecting its price equilibrium. In practice, this refers to the speed at which we can take or withdraw a position without significantly disrupting market dynamics. High liquidity assets allow for easy and quick transactions with minimal price deviation. In contrast, assets with limited liquidity suffer from difficult turnover and often have to endure significant price changes to close our position.

Cash and its equivalents are traditionally considered the pinnacle of liquidity, as they can be easily converted into other stores of value. In the crypto space, this role is taken on by stablecoins – virtual currencies pegged to the real value of traditional assets. Although they are still not the primary tool for everyday payments in most countries, the share of stablecoins in the overall cryptocurrency volume is already significant, making them particularly liquid assets.

Conversely, real estate, luxury cars, or ancient artifacts fall into the category of relatively illiquid assets. Owning a unique historical item does not guarantee that we will find a buyer at the desired price. Even if we need a specific car in exchange for our artifact, it is practically impossible to find the exact one. This is why currency continues to be indispensable in the economy. Tangible assets have a lower liquidity coefficient due to their very physical nature – moving them requires time and additional resources. Crypto assets, on the other hand, which are pure digital code, can be transferred almost instantly between devices, putting them in a more favorable position concerning liquidity. It is advisable to understand liquidity as a continuum, where at one end we have cash and stablecoins, and at the other end – extremely illiquid artifacts. Each asset occupies its position within this range.

Two main types of liquidity

In the traditional financial market, we recognize two main categories of liquidity – accounting and market.

Liquidity is a term primarily used in analyzing corporate balance sheets. It refers to a business's ability to meet its current obligations with its available resources and revenues. This is a direct indicator of the company's financial stability and solvency.

Market liquidity, on the other hand, describes the degree to which a market is able to facilitate the buying and selling of assets at prices that correspond to their true value. In this context, true value means the minimal difference between the lowest selling price (Ask price) and the highest buying price (Bid price).

The spread between buying and selling

The difference between the price at which sellers are willing to part with their assets and the price at which buyers are eager to acquire them is called the spread. A low spread is a favorable sign of healthy liquidity in a market – it indicates that price imbalances are quickly corrected by active participants. A huge spread usually signals that the market is suffering from a liquidity crisis and that there is a large gap between the aspirations of buyers and sellers.

The spread between buying and selling is also a useful tool for so-called arbitrage traders, who profit from price discrepancies. Their actions, although inherently outbound, actually enhance overall liquidity by narrowing the spread and providing more favorable conditions for other participants. They also ensure that there are no dramatic price deviations for the same asset pair across different platforms. Have you noticed how the price of Bitcoin remains almost identical across all major cryptocurrency exchanges? This is a result of the activities of arbitrage traders, who continuously move between platforms and prevent large price differences.

The Liquidity Crisis and Its Consequences

Although crypto assets, as digital products, are theoretically supposed to possess high liquidity, in practice it is far more complex. Some cryptocurrencies have significantly better liquidity than others, which is a direct result of trading volume and market efficiency. While Bitcoin and Ethereum enjoy huge daily volumes exceeding billions of dollars, quite a few alternative cryptocurrencies operate with volumes measured only in thousands. For traders dealing with illiquid crypto assets, the risk is real. If you get involved in a position with insufficient market interest, exiting at the desired price becomes almost impossible, leaving you “locked” with the unwanted asset.

When you try to execute a large order in an illiquid market, the occurrence of a phenomenon known as “slippage” is practically guaranteed. Slippage is the difference between the expected price and the actual execution price. High slippage means that the actual executed price is far from your intended price – usually because there are not enough active orders in the order book near your target price. One way to avoid slippage is by using limit orders, but then you risk your order never being filled. During periods of financial stress, liquidity can drastically deteriorate as investors quickly close positions to meet their financial obligations.

Concluding Thoughts

Understanding liquidity is essential when assessing financial markets. To minimize risk and have sufficient flexibility in managing positions, it is advisable to rely on assets and trading pairs with adequate liquidity. This allows you to enter and exit positions with minimal difficulties and financial losses.