What Is Market Liquidity And Why Does It Matter?

Financial markets need to offer ample liquidity to traders to become of interest. Converting between assets or investment vehicles needs to be a smooth and enjoyable experience. Whether it is a cryptocurrency or stock, it all comes down to how liquid the trading experience is.

Table of contents

  • What Is The Purpose Of Market Liquidity? 
  • Figuring Out A Market’s Liquidity
    • Examples Of Liquid Assets
    • Examples Of Illiquid Assets
  • Analyzing Market Liquidity
  • Figuring Out The Order Book
  • Why All Of The Above Matters
  • Potential Risks And Downsides
    • Liquidity Benefits
    • The Potential Downsides
  • Conclusion

What Is The Purpose Of Market Liquidity? 

For those who are unaware of why any of this matters, market liquidity depicts the extent to which one can safely buy and sell assets at stable and transparent prices. This applies to any financial market type, including precious metals, stocks, and cryptocurrencies. Although one can – int theory – exchange any asset for any other asset, the market for trading  plush toys for furniture – as an example – is very limtied, non-transparent, and will hardly have any liquidity. 

There are different ways to interface with these markets and finding liquidity to either buy or sell the asset is not too difficult. However, it is advisable to gauge whether the volume is dominated by selling or buying. A market with an equilibrium between the two will often prove more worthwhile. Having an equilibrium ensures sellers don’t have to lower the price of the asset to find a buyer, and buyers don’t have to overextend their bidding price to meet seller demand.

In the end, traders prioritize the ability to open and close market positions quickly. Having to wait for an order to be picked up by either a buyer or seller creates a lot of friction and makes neophyte traders extremely nervous. In liquid markets, this will pose far less of an issue, giving traders and speculators peace of mind.

A rule of thumb is how market liquidity is never a “fixed value”. In fact, it is subject to ebbs and flows, just like any other financial tool is. Market dynamics will ensure the balance can shift from high to low liquidity and back again on a regular basis. It all comes down to the number of traders and time of day, especially when engaging with overseas markets. 

Figuring Out A Market’s Liquidity

Contrary to what some people may think, not all financial markets are liquid. More specifically, it can be challenging to enter or exit specific markets at preferred prices, as there may not be enough buyers or sellers to trigger a market move. When that happens, the trading experience becomes rather frustrating and often incurs financial losses. 

The trading volume for any market is often a strong indicator of how much liquidity there is. In the cryptocurrency industry, trading volume is spread among different exchanges and trading platforms. Analyzing the performance of every individual platform is crucial; otherwise, there may be an illiquid period. 

Examples Of Liquid Assets

Most people around the world use the most liquid asset on the planet today: cash. There is never a shortage of banknotes and coins, allowing consumers to make transactions at their leisure. For merchants accepting cash will enable them to cater to a broad user base, even though the concept has fallen out of favor a bit in recent years. 

For cryptocurrencies, many people would consider Bitcoin to be a liquid asset. That label can apply to the leading cryptocurrency, but its inherent volatility is a factor to consider at all times. Instead, stablecoins, such as Tether’s USDT, are the enablers of liquidity. It is possible to trade stablecoins against any crypto-asset with relative ease. 

Examples Of Illiquid Assets

To the average onlooker, real estate or collector’s items may seem like liquid assets as well. After all, there is usually at least one buyer for these items. However, it can take weeks, months, or years to sell the real estate or collector’s items. Finding the right buyer is a time-consuming process and may not even be a guarantee either. 

One also has to keep in mind that you can’t exchange real estate or collector’s items for other assets easily. More specifically, you can buy a private jet with cash, precious metals, or sometimes even cryptocurrencies. Trading a small house for a private jet – or a rare collector’s item – will not happen anytime soon. 

Tangible assets are – bar a few exceptions – mainly illiquid. Exchanging physical value is a cumbersome and often expensive process, whereas one can settle digital exchanges of value much quicker and hassle-free. 

Analyzing Market Liquidity

Shifting back to our digital markets, it is pertinent for traders to analyze how much market liquidity there is. Knowing how easy or difficult it will be to convert between assets ahead of time can help you avoid headaches and worries. 

Thankfully, it is often straightforward to gauge the market liquidity. Trading platforms usually provide a bid-ask order book, allowing users to see where the orders are placed and for which amounts. An order book is an ever-evolving creature, though, and these values may not stick around forever.

Figuring Out The Order Book

The order book depicts how much buyers and sellers are asking to trade their holdings. There is often a gap between the top buy order and the lowest sell order, creating a “bid-ask spread”.  Liquid markets will have a shallow spread, whereas illiquid markets may see a spread of 5% or more. Avoiding these latter markets 

A trader can see how much liquidity there is for this particular market in the image above. Both buy and sell sides of the order book have a lot of volume in open orders. It is crucial to keep in mind these orders can be canceled and moved lower or higher at any given time. Some of them may belong to trading bots, but overall, there is plenty of volume to enter and exit a market quickly. 

As a supplement, arbitrage traders will often seek out liquid markets to exploit minor price differences over and over again. As more arbitrage traders explore the same markets, the bid-ask spread tends to grow smaller, benefitting all traders. Arbitrage keeps the price differences to a minimum, ensuring a similar price across the different trading platforms. 

Why All Of The Above Matters

The tangent above may seem a bit confusing to neophyte traders, as they may think liquidity is far less of an issue. However, any market’s liquid aspect makes a big difference between a fun trading experience and being unable to exit positions for days, if not weeks. 

A good example is the cryptocurrency industry. Top assets like Bitcoin, Ethereum, and a few others generate billions of dollars in daily trading volume. As such, buying and selling BTC or ETh is often straightforward. However, that doesn’t necessarily apply to alternative currencies as their market liquidity is usually much lower. 

Building up a position in an illiquid market is not ideal, as it often leads to bag holding. The concept of bagholding refers to holding an asset that cannot be sold at the desired price without triggering a significant market effort. In some cases, traders will sell 75% of their position at a profit, yet 25% at a loss, as there are not enough people buying at higher prices. It is an unfortunate scenario, but it can happen to anyone.

Potential Risks And Downsides

Even when one gains sufficient understanding of market liquidity, there are still potential benefits and risks to take into account. Overlooking these concepts is ill-advised, as traders need to familiarize themselves with these aspects to make the most of periods with high or low trading volume. 

Liquidity Benefits

As more liquidity enters the market, it is often safe to assume that particular asset will remain healthy for the foreseeable future. Many traders also consider an increase in trading volume to be a sign of global stability and prosperous times ahead.

That being said, even during times of low liquidity, there can be multiple benefits to traders. The COVID-19 pandemic has shown that companies handling the situation creatively can still see their stock price appreciate, for example. As such, it advisable to look at fundamental analysis when gauging the liquidity of a market. 

The Potential Downsides

Not every period of low liquidity will be beneficial for traders. In fact, neophyte traders will often themselves be in an awkward position during these periods. it is more difficult to properly assess a market and its risks. Unstable price and worsening market conditions are often impossible to predict. Price manipulation is relatively common during these periods, which can yield surprising and catastrophic events. 

Having significant exposure to an illiquid asset is often something to prevent. although the market outlook may indicate steep returns in the future, those may never materialize. All it takes is for one investor to sell off their holdings and trigger a significant market dump. It can easily be the catalyst for a bear market and the associated panic. 

As more investors bail on a specific asset, it will create a steep drop in the already limited market liquidity. Less trading volume means even more price instability and potential manipulation. 

Conclusion

Like other aspects of trading, analyzing a market’s liquidity is crucial for anyone looking to enter or exit a position. Trading in illiquid markets is often a death sentence for one’s potential profits. Stick to markets that have a healthy order book with many buy and sell orders on either side. 

Even if the profit potential is more significant in an illiquid market, you may never be able to sell at that desired price. Avoid situations like those at all costs.

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