Understanding Liquidity

The concept of liquidity has many facades to it. One way to define liquidity is “the ability of an asset to be converted into cash readily on demand”. An additional way of viewing at it is when any asset can be bought or sold at its fair price. Liquidity thus means that there aren’t discounts or bonuses devoted to it during buy or sell and it’s easy to enter and exit the asset. It is believed as more of an item is accepted and sold, the chances of charging premiums or giving discounts lower and such an asset usually trades around ‘what it is worth’.

The forex market is often defined as a liquid market with an average turnover of more than $5 trillion daily as of April 2016 according to the Bank for International Settlements (BIS) while real estate is a classic example of an illiquid asset. Property as an asset is less liquid, requiring huge investments into physical form, monotonous procedures and smaller market. 

Liquidity is significant for any tradable asset, which comprises the math-based currency Bitcoins as well. Liquid markets are deeper and smoother while illiquid market can put traders in a spot from where it’s hard to circumnavigate the way out. Bitcoins have seen a significant grown in the last five years of its existence from 50 Bitcoins in 2009; the circulation is more than 16.78 million today. The graph above depicts the growth of Bitcoins in terms of circulation. However, the virtual currency has viewed episodes of illiquidity. Let’s take a look at the main factors which influence the liquidity of the Bitcoins.

How to tell if a market is liquid

There are three significant indicators that can help determine if a market is liquid or illiquid: 24-hour trading volume, order book depth, and the bid-ask spread. the bid-ask spread is the difference between the lowest ask price and the highest bid price.

However, the order book might not always be an accurate representation due to factors like stop-limit orders and iceberg orders, which are not always visible in the order book. Liquidity is extremely important when considering your trades. It is one key factor for easily entering or exiting a particular market.