What Is Liquidity In Cryptocurrency

Liquidity is an important indicator for investors and traders, as it shows the ease with which a crypto asset can be bought or sold. Therefore, understanding liquidity is essential for anyone who plans to become a crypto market participant. Keep reading this article to learn more about liquidity, its role in trading, and ways of calculating it.

What Is Liquidity?

As we’ve already mentioned, liquidity indicates the ease of buying and selling the cryptocurrency without a strong impact on its price. High liquidity allows open and close positions with minimal slippage, while low liquidity implies more time-consuming buying and selling, which potentially leads to large changes in price. Thus, liquidity affects the speed and cost of transactions, as well as the stability of crypto value.

Liquidity is higher for assets that have great market popularity, large number of exchange listings, and high market capitalization. Good liquidity to market cap ratio is 5% or more. For example, these include Bitcoin, Ethereum, Solana, USDT, and others.

Why Is Liquidity Important In Cryptocurrency Market?

Let's take a closer look at the reasons why liquidity is so essential in the crypto market. Here is what it exactly does:

• Maintains stable prices. A liquid market is characterized by high trading activity, which brings supply and demand into harmony. Thus, sharp price fluctuations are minimized.

• Clarifies price determination. Due to stability, the liquid market gives the most accurate valuation. This helps in planning a personal investment strategy.

• Prevents price manipulation. A liquid market is less susceptible to price controls and manipulation by unscrupulous participants. This increases the security of being in the space.

• Analyzing trading activity. Liquidity indicates an increase in the number of buy and sell orders, allowing traders to understand market forces. Due to this, investors can better analyze the market and make forecasts.

• Makes trading efficient. The higher the liquidity, the faster transactions are made, preventing large price fluctuations. Moreover, the difference between the price of buying and selling (also called the spread) is smaller, which reduces the transfer costs, making trading profitable.

Low Liquidity Vs. High Liquidity

As you can see, high liquidity is the optimal level for the market. To better understand its importance, let's compare high liquidity with low liquidity.

How Does Liquidity Impact Trading?

Now that you've seen the difference between high and low liquidity, let's “summarize” and learn in more detail about what advantages high liquidity brings to trading:

1. Price stability. Large trades have less impact on the market, keeping prices stable; this is connected with the great number of orders. Moreover, these numbers reflect the collective views of market participants, so they are more accurate.

2. High speed of execution. Transactions are made faster due to a great number of buyers and sellers, so the time to enter and exit a position is reduced.

3. Profitable trades. The difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept is lower. Because of this, traders can transact at more favorable prices.

4. Flexibility in making trades. Traders have an opportunity to make deals of different sizes, which is suitable for both retail and institutional traders. This range of positions does not affect the market.

How To Calculate Liquidity Of A Crypto Or An Exchange?

As you have already realized, liquidity is one of the most important issues in trading and the crypto market in general. Traders should be able to make transactions in the preferred currency pair and on the suitable exchange, but not all of them have a sufficient level of liquidity. The decision is to measure it.

Unlike crypto market indicators, liquidity does not have a fixed value. However, there are several factors that can be considered when analyzing its level, including trading volume, market depth, and others. Thus, it is possible to evaluate the liquidity of a cryptocurrency and a crypto exchange. The factors of their assessment are similar, but with their peculiarities.

How To Calculate Liquidity Of A Crypto?

Consider the factors for assessing cryptocurrency liquidity:

Trading volume

This is the total number of coins and tokens that have been traded in a certain period (usually estimated in the last 24 hours). The higher the value, the higher the liquidity.

Formula: Trading volume = Number of coins sold in 24 hours

Order book depth

This indicator shows the number of buy and sell orders at different price levels. The more orders, the higher the liquidity.

Formula: Order book volume = Sum of buy and sell orders at different price levels

Price-to-earnings ratio (spread)

This shows the difference between the highest price of an asset that someone is willing to pay (bid) and the lowest price that someone is willing to sell (ask). The lower the spread, the higher the liquidity.

Formula: Spread = Ask price - Bid price on an asset

Market depth

The indicator combines order book depth and spread, so it gives a broader view of liquidity. It shows how many orders are placed at different price levels and how far the order book needs to be moved to make a large trade without a big impact on the market price.

Formula: Market depth = Number of orders at different price levels in the order book

How To Calculate Liquidity Of An Exchange?

To measure the liquidity of a crypto exchange, it is worth looking at its liquidity index, an element that includes a combination of factors, among which are trading volume, order book depth, order book volume, bid-ask spread, and market depth.

Let's now take a closer look at how to estimate liquidity on a crypto exchange:

Trading volume

This indicator evaluates the trading activity, emphasizing that users can easily open and close positions in a certain period (usually 24 hours). If you trade certain assets, you should look at the liquidity of your trading pair rather than the liquidity of the exchange as a whole. You need to look at the number of transactions on trading pairs: the more there are, the higher the liquidity.

Formula: Trading volume = Total number of transactions for all currency pairs for 24 hours

Order book depth

This is the number of orders to buy and sell on the exchange at different price levels. The higher the figure, the higher the liquidity.

Formula: Order book depth = Sum of buy and sell orders at different price levels in the order book

Price-to-bid ratio (spread)

This shows the difference between the highest bid price and the lowest offer price of the trading pair on the exchange. The lower the spread, the higher the liquidity.

Formula: Spread = Ask Price - Bid Price, for each trading pair

Market depth

This figure considers the size and price levels of buy and sell orders in the order book. The higher the value, the higher the liquidity of the exchange.

Formula: Market depth = Total number of buy and sell orders at different price levels

Thus, the level of liquidity impacts how easily, quickly, and profitably traders can execute deals. The higher the liquidity, the faster trades will be made, as well as lower costs and more stable prices will be. If liquidity is low, it can lead to delays in executing trades, high costs, and volatility.

We hope our guide helped you better understand the nature of liquidity and its importance in the crypto market. If you still have questions, feel free to leave them in the comments!