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This guide to cryptocurrency liquidity takes a look at how to measure liquidity and trade well. Understanding indicators to analyze liquidity is vital in the cryptocurrency world.

In the fast-paced cryptocurrency markets, liquidity is a vital concept that every trader or investor needs to fully grasp before making any investment decision. Understanding liquidity will help you to navigate the pain points when you’re considering to buy or sell a particular cryptocurrency, ensuring that you do not incur higher trading costs or inefficiencies that can throw you off guard. In the previous article, we’ve explained the importance of liquidity and the factors that affect it. This guide will be dedicated towards uncovering the different indicators that measure liquidity and how you can utilize them to trade effectively.

Let’s dive into what the definition of liquidity:

Liquidity refers to the degree to which a particular asset can be quickly bought or sold without affecting the general stability of its price.

Here’s an illustration that breaks down liquidity:

Cryptocurrency Liquidity: Liquidity in the Cryptocurrency Market

In the context of cryptocurrencies, liquidity can be broadly defined as the ability of a coin to be converted into cash or other coins easily without disrupting prices. A high liquidity is always preferred, since it is indicative of a vibrant and stable market. In a highly liquid market, participants can trade easily, quickly and at fair prices. A similar example is when you try to buy fresh produce at your local markets; there is a higher tendency for you to shop at a bustling market with lots of sellers and buyers rather than a market with few market participants.

Let’s take a look at the daily trading volume – which is a measure of liquidity – of cryptocurrencies as compared to traditional financial assets:

Due to the infancy of cryptocurrencies and its technology, the market is still considered illiquid since it is not ready to absorb large orders without changing the value of the coins. Illiquid markets tends to be highly volatile since anyone with a larger order can easily disrupt – or worse, manipulate – cryptocurrency prices.

(Read more: Bitcoin vs Alt Coins Returns: Comparison of Gains Between Bitcoin & Altcoins Investing)

How Can We Measure Liquidity?

The 2 most common indicators to assess liquidity is volume and the Bid-Ask spread.

1. Volume

Volume refers to the number of coins traded in a single market during a given period of time. Volume can indicate the direction and movements of the current market trend. Greater trading volume equates to more trading activity (selling and buying) and is therefore a liquid market. Additionally, a higher volume backing a market trend – either a decrease or increase in cryptocurrency prices – signifies higher market activity backing the overall trend. This would potentially bring more sustainability of a given move. For example, a drop with considerable volume behind it might mean a coin is in for an extended bear run. If price movements are not backed by volume, this would however indicate that only a small number of people are backing the current price trend and therefore, it may be short-lived. In fact, spikes in prices when trading volume is low can be an indicator of price manipulation.

It is important to note that volume is often measured in USD value. For instance, if the 24-hour volume of Bitcoin’s market is USD $300 million, it means that the total value of Bitcoin transacted within a span of 24-hours and across all exchanges amount to USD $300 million. Volume can be divided into 3 main categories.

(See also: Crypto Trading Guide: 4 Common Pitfalls Every Crypto Trader Will Experience)

A. Total Trading Volume of a Coin

This refers to the total trading volume across all exchanges that offer trading of a single coin. This is used to gauge the general market liquidity of a specific coin; a coin with higher trading volume is more liquid and is preferred since there it’s much easier to enter or exit into a trade. You can get the 24-hours volume data for a single coin at CoinMarketCap. Here’s an example of Ether (ETH) and EOS (EOS):

Highlighted in red is the total volume of ETH and EOS traded on all exchanges. You can see that ETH has a higher total daily volume at $1.8 billion compared to EOS, which has a volume of $697 million. Just looking at the absolute total trading daily volume, we can see that ETH has higher liquidity as compared to EOS. This makes trading ETH a better option, since it will be much easier and quicker to buy or sell ETH due to greater market activity.

A more extreme example to highlight the importance of liquidity would be to choose a coin further down the list:

Compared to ETH’s trading volume of $1.8 billion, Terracoin (TRC) only has a volume of $2,761. TRC is extremely illiquid since there is a severe lack of trading activity. A single buy or sell order would significantly affect TRC’s prices, thus making it more vulnerable to worrying levels of volatility and manipulation. It is therefore wise to stay away from trading illiquid coins unless they have garnered a suitable trading mass.

(Read also: Coins, Tokens & Altcoins: What’s the Difference?)

B. Total Volume of an Exchange

This refers to the total trading volume of all coins within an exchange. This is used to gauge the liquidity of an exchange; an exchange with a higher liquidity is better to trade on since there are more market participants and trading activity in that exchange. Additionally, this metric is used to measure the size of the exchange. All exchanges are ranked according to their volume, exchanges with greater volume equates to them being bigger in size.

In order to find the total volume of an exchange, you can visit CoinMarketCap, as can be seen below:

The goal is to trade on cryptocurrency exchanges that have a higher trading volume, due to the previously mentioned benefits of liquidity. It must be mentioned that liquidity does not correlate with the number of coins or coin pairs available for trading on an exchange; an exchange that offers more coins and currency pairs doesn’t mean it is more liquid than an exchange that offers a lower number. BY looking at the table above, you can see that HitBTC has 761 markets as compared to the 380 markets offered by the largest exchange, Binance.

A ‘market’ refers to a single trading pair. A coin may have several markets or trading pairs. For instance, Bitcoin (BTC) can have 5 markets: BTC/USD, BTC/USDT, BTC/ETH, EOS/BTC and ETC/BTC. Therefore, an exchange with 100 markets doesn’t mean that there is 100 varieties of coins available on an exchange.

A greater overall trading volume signifies an exchange is more liquid. You should always trade on exchanges with a higher trading volume to enjoy better prices and quicker trades.

Currently, the biggest exchange in the cryptocurrency world is Binance, which has a trading volume of more than $1 billion in a 24-hour period. If you look at the trading volume of exchanges, you’d find that crypto-only exchanges have much higher volumes than fiat-accepting exchanges. Fiat-accepting exchanges have lower liquidity due to more stringent regulations, rigid verification process and limited trading pairs.

(See also: Guide to Market Capitalization: Everything You Need to Know About Market Cap)

C. Total Volume of a Trading Pair

This refers to the volume associated with a single trading pair. A single coin can have multiple trading pairs since it can be traded with other coins. For instance, Bitcoin can be traded against fiat currencies (USD/GBP/CAD/EUR) and other coins (BCH/ETH/XLM/XRP/ USDT). This metric is used to gauge the liquidity of the trading pair that you’re going to trade in. If you’re interested in buying Bitcoins with Bitcoin Cash (BCH), then you must look at the liquidity BTC/BCH pair. This is perhaps the most important indicator to look at. You should always trade the coin pair at the exchange with the highest liquidity. This data can be found on CoinMarketCap:

If you want to find this category of data, simply go to CoinMarketCap > Find the coin you’re interested in Trading > Click on ‘Markets’ Tab > Click on ‘Pair’ and Find the Currency You’re buying the Coin With. Following the example above, you’ll be looking at the pair BCH/BTC if you’re keen on getting BCH with some BTC that you own. Based on the rankings, Huobi exchange has the highest volume for the BCH/BTC pair, which therefore makes it the best place for you to trade specifically for that trading pair. Trading the BCH/BTC pair on an exchange with low volume will make it hard for you to execute orders and would also lead to higher trading costs, due to a higher bid-ask spread which will be covered later.

It is interesting to note that the biggest exchange – based on total cryptocurrency volume – is ranked 5th for the BCH/BTC coin pair. This goes to show that looking only at the liquidity of an exchange is insufficient; you have to ultimately look at the liquidity of the specific coin pair that you’re interested to trade on.

Here is the list of possible actions for a specific coin pair, in this case the BCH/BTC pair:

If you want to buy BCH using BTC / If you want to sell BTC to get BCH (Same action, different perspective)

If you want to sell BCH and get BTC / If you want to buy BTC using BCH (Same action, different perspective)

(Read also: A Guide To Fundamental Analysis For Cryptocurrencies)

2. Bid-Ask Spread

If you go to any cryptocurrency exchange, you can see an order book that showcases all buy orders (created by buyers) and sell orders (created by sellers). The order book is a great indicator of liquidity since you can assess if the coin pair that you’re interested in is liquid or not. You can assess the bid-ask spread by looking at the order book. Bid-ask spread is defined as the difference between the bid price and the ask price for a coin.

Bid Price: The price a buyer is willing to pay for a coin

Ask Price: The price at which the seller is willing to accept for a coin

Here is an example of Bitcoin Cash (known as BCH or BCC. In this case, it is the latter) and Bitcoin (BTC) trading pair on Binance:

In any market, sellers would naturally want to sell at a high price to get more profits, while buyers would want to buy at a cheaper price. You can calculate the bid-ask spread by taking the difference of the lowest ask price (sell order) and the highest bid price (buy order).The most liquid assets have the smallest bid-ask spread while in less liquid markets, the spread between buying and selling prices tend to be much wider. A wider spread in an illiquid market makes it more expensive to trade since you have to pay a premium to buy or sell at a lower price.

The example above showed that the BTC/BCC bid-ask spread is 0.00025 BTC ($1.57). This is considered quite low. Here is an example of a wide bid-ask spread due to a lack of volume and liquidity:

The above order book was taken from Cobinhood exchange, which had an illiquid BCH/BTC trading pair given large wide spread. Cobinhood’s bid-ask spread is $37.03 while Binance’s spread was only $1.57. If you were to trade the BCH/BTC trading pair in Cobinhood, it is going to be less efficient and more expensive. You can also observe that in an illiquid exchange such as Cobinhood, the size of the orders (‘Amount’ column) were much smaller than the average orders in Binance. This means that if you were to buy a larger amount of BCH, you could affect the prices easily, thereby causing great volatility.

A greater trading volume for the coin pair means that there are lots of sellers and buyers that are interested to trade the coin pair. It is not recommended to trade obscure coin pairs which have limited popularity and trading volume can impair your investment positions.

(See also: Beginner’s Guide to ICO Investing: How to Participate in ICOs)

Putting It All Together

It is vital for anyone to assess the liquidity of the markets they’re about to enter before making any investment decisions. Investing in an illiquid exchange or coin pair could increase your difficulty in trading the coin and also result in higher execution costs. There are several indicators at your disposal that that you can utilize in assessing liquidity, such as looking at the average total volume of a coin, trading volume of the exchange, trading volume of the specific trading pair, and also analysing the coin pair’s bid-ask spread.

Beneficial Resources To Get You Started

If you're starting your journey into the complex world of cryptocurrencies, here's a list of useful resources and guides that will get you on your way:

Trading & Exchange

Wallets

Read also: Crypto Trading Guide: 4 Common Pitfalls Every Crypto Trader Will Experience and Guide To Cryptocurrency Trading Basics: Do Charts & Technical Analysis Really Work?

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