Liquidity and Crypto Trading

Liquidity: Definition in Trading

Liquidity refers to the efficiency or ease with which an asset or security can be exchanged and converted into cash without affecting its price. The most liquid asset of all is theoretically cash itself. That said, with the limitations of spending and even owning banknotes, this may change in the future! And why shouldn’t the most liquid assets become one day the decentralized cryptos for example?

Liquidity: An Essential Notion in Trading!

In other words, liquidity describes the extent to which an asset can be quickly bought or sold in the market at a price that reflects its intrinsic value. Banknotes (cash) are universally considered the most liquid asset because they can be quickly and easily converted into other assets. Tangible assets, such as real estate, art and collectibles, are all relatively illiquid. Other financial assets, ranging from stocks to corporate shares, are at different levels on the scale from least to most liquid.

For example, if a person wants to buy a $500 television set, cash is the asset that can most easily be used to obtain it. If that person has no cash but a collection of rare stamps that has been valued at $500, it is unlikely that he or she will find someone willing to trade the TV for his or her collection. Instead, she will have to sell her collection and use the money to buy the TV. This may be fine if the person can wait months or years to make the purchase, but it may be a problem if they only have a few days. They may have to sell the stamps at a discount, instead of waiting for a buyer willing to pay the full value. Rare stamps are an example of an illiquid asset.

Liquidity: Both definitions in finance.

Be careful not to confuse the liquidity of a market with the liquidity of a company

1. Market liquidity

Market liquidity refers to the extent to which a market, such as a country’s stock market or a city’s real estate market, allows assets to be bought and sold at stable and transparent prices. In the example above, the market for televisions in exchange for rare stamps is so illiquid that it does not exist.

The stock market, on the other hand, is characterized by greater market liquidity. If an exchange has a high volume of trading that is not dominated by selling, the price a buyer offers per share (the bid price) and the price the seller is willing to accept (the ask price) will be fairly close to each other.

Investors will not have to give up unrealized gains for a quick sale. When the bid-ask spread narrows, the market is more liquid; when it increases, the market becomes more illiquid. Real estate markets are generally much less liquid than stock markets. The liquidity of markets for other assets, such as derivatives, contracts, currencies or commodities, often depends on their size and the number of open exchanges on which they can be traded.

2. Accounting liquidity

Accounting liquidity measures the ease with which a person or company can meet its financial obligations with the liquid assets at its disposal, i.e. the ability to repay its debts when due.

In the example above, the rare stamp collector’s assets are relatively illiquid and would probably not be worth their full value of €500 in the event of trouble. In investment terms, the assessment of book liquidity consists of comparing liquid assets to current liabilities, i.e. financial obligations that mature within a year.

There are a number of ratios that measure accounting liquidity and differ in the rigor with which they define “liquid assets.” Analysts and investors use them to identify companies with significant liquidity.

Liquidity measurement

Financial analysts look at a company’s ability to use its liquid assets to cover its short-term obligations. In general, when using these formulas, a ratio greater than one is desirable.

The liquidity ratio is the most demanding of the liquidity ratios. Excluding accounts receivable, as well as inventories and other current assets, it defines liquid assets strictly as cash or cash equivalents.

In terms of investments, stocks as a class are among the most liquid assets. But not all stocks are equal in terms of liquidity. Some stocks trade more actively than others in the stock markets, which means there is a larger market for them. In other words, there is greater and more consistent interest from traders and investors. These liquid stocks are generally identifiable by their daily volume, which can be in the millions or even hundreds of millions of shares.

Role of liquidity: facilitating trade

If markets are not liquid, it becomes difficult to sell or convert assets or securities into cash. For example, you may have a very rare and valuable family heirloom valued at €200,000. However, if there is no market (i.e. no buyers) for your item, it doesn’t matter since no one will pay anywhere near its estimated value – it is very illiquid. It may even be necessary to use an auction house to act as a broker and search for potential interested parties, which will take time and incur costs.

Liquid assets, on the other hand, can be easily and quickly sold at full value and at little cost. Companies also need to hold enough liquid assets to cover short-term obligations, such as bills or salaries, or else face a liquidity crisis, which could lead to bankruptcy.

Most liquid assets or securities

Cash is the most liquid asset, followed by cash equivalents, i.e. money markets, certificates of deposit or time deposits. Marketable securities such as publicly traded stocks and bonds are often very liquid and can be sold quickly through a broker. Gold coins and certain collectibles can also be easily converted to cash.

Most illiquid assets or securities?

Securities traded over the counter (OTC), such as some complex derivatives, are often quite illiquid. For individuals, a house, timeshare or car are all somewhat illiquid in that it takes several weeks or even months to find a buyer, and several more weeks to finalize the transaction and receive payment. In addition, brokerage fees tend to be quite high (for example, 5-7% on average for a real estate agent).

Are some stocks more liquid than others?

The most liquid stocks tend to be those with high interest from different market participants and high daily trading volume. These stocks also attract a larger number of market makers who maintain a tighter two-sided market. Iliquid stocks have wider bid-ask spreads and less market depth. These names tend to have lower name recognition, lower trading volume, and often also lower market value and volatility. For example, the stock of a large multinational bank will tend to be more liquid than that of a small regional bank.

Liquidity: what does it mean on the Crypto markets?

As we have just seen, liquidity describes the state of an asset in terms of the ease with which it can be bought or sold. A market is therefore considered liquid if it allows trading at stable prices. It is ultimately a measure of the quantity of current and potential buyers and sellers in a market. Generally, more liquid markets trade at higher volumes, but volume alone does not necessarily imply the presence of sufficient liquidity.

More important than the volume traded is the willingness of the participants to buy and sell at an agreed-upon price that does not involve the other party suffering a substantial loss in the transaction itself. In other words, the buyer does not need to pay much above what he considers a fair price, and the seller does not need to sell much below what he considers the fairest price.

For a cryptocurrency trader, the liquidity of this specific market is just as important as for other markets.

One of the most important questions any trader should ask themselves before getting into action is, “Is anyone available or willing to take the trade?” In other words, “Is the market I want to trade in now sufficiently liquid?” or “Is there a risk that my orders will not be executed due to lack of liquidity?”

So, for any investment, one of the most important considerations is the ability to effectively buy or sell that asset whenever the investor wants. After all, what’s the point of making a profit if the seller is not able to realize his or her gains? The liquidity of the asset will largely determine whether and to what extent a prudent investor will take a position in the investment – and this extends to bitcoin and other crypto-currencies.

Crypto-currency liquidity refers to the ease with which a digital currency or token can be converted into another digital asset or cash without impacting the price and vice versa. Since liquidity is a measure of the external demand and supply of an asset, a deep market with abundant liquidity is an indication of a healthy market. Additionally, the more liquidity available in a crypto-currency or digital asset, all else being equal, the more stable and less volatile that asset should be.

In other words, a liquid crypto-currency market exists when someone is willing to buy when you are looking to sell; and vice versa. This means that you can buy that digital asset in any amount you want, take advantage of a trading opportunity or, in the worst case scenario, cut your losses if the value of the asset falls below your costs, all without moving the market dramatically.

Benefits of a liquid crypto market

• The ease with which a digital token can be converted into a digital asset or cash without affecting its price is called liquidity in crypto-currencies.
• The liquidity of crypto-currencies reduces investment risk and, more importantly, makes it easier to develop an exit strategy, making it easier to sell your holdings.
• The liquidity of crypto-currencies helps stabilize prices and reduce volatility, while making it easier for traders to analyze their activity.

The importance of liquidity in crypto-currencies

Like any market, the crypto-currency market depends on liquidity. Liquidity in crypto-currencies reduces investment risk and, more importantly, helps define your exit strategy, making it easier to sell your capital. Therefore, as crypto traders we should favor liquid crypto-currency markets.

1. The liquidity of crypto-currencies makes price manipulation difficult

The liquidity of crypto-currencies makes them less susceptible to market manipulation by rogue players or groups of players.

As a nascent technology, crypto-currencies currently have no clear path; they are less regulated and have many unscrupulous people looking to manipulate the market to their advantage. When considering a liquid digital asset with volume such as Bitcoin, controlling the price action in this market becomes difficult for a single market player or group of players.

2. The more liquid a crypto-currency is, the more price stability and less volatility it offers.

A liquid market is considered more stable and less volatile, as a thriving market with considerable trading activity can tend to balance out selling and buying forces.

Therefore, whenever you sell or buy, there will always be market participants willing to do the opposite. People can initiate and exit positions in very liquid markets with little slippage or price fluctuations.

3. The liquidity of crypto-currencies allows us to better analyze the behavior of other traders.

The liquidity of crypto-currencies is also determined by the number of interested buyers and sellers. Increased participation in the market means increased liquidity, which can be a signal of a change or even a reversal in the market.

A larger number of buy and sell orders reduces volatility and gives us an overall picture of the market forces at play and can help us produce more accurate and reliable technical data. This allows us to better analyze the market, make accurate forecasts and make informed decisions.

4. Evolution of the liquidity of crypto-currencies

Futures markets (“futures”) have emerged for the most prominent crypto-currencies, including bitcoin and Ethereum. Futures markets allow investors to trade contracts, or agreements, to buy or sell crypto-currencies at a pre-agreed future date in an easy and transparent manner.

They allow investors not only to buy and hold a future claim on an asset such as bitcoin, but also to sell BTC short through futures contracts, which means that one can short bitcoin without owning it. The market makers of these futures contracts have to manage their own risk by providing liquidity in crypto-currencies which enhances the overall market liquidity.

Measuring the liquidity of crypto-currencies

Liquidity, unlike other trade analysis indicators, has no fixed value. Therefore, it is difficult to calculate the exact liquidity of an exchange or market. However, there are indicators that can be used to measure liquidity in the crypto-currency market: spread, trading volume, market size.

1. The gap between supply and demand: the spread

The difference between the highest buy price (bid) and the lowest sell price (ask) in the order book is known as the spread. The smaller the spread, the more liquid a crypto currency is considered to be.

If the market for a digital asset is illiquid, investors and speculators expect to see a wider bid-ask spread, making it more expensive to trade that digital asset.

2. The volume of exchange

Trading volume is an important factor in determining the liquidity of the crypto-currency market. It is the total amount of digital assets traded on a crypto-currency exchange over a given period of time.

This indicator has an impact on the direction and behavior of market participants. A higher trade value indicates greater trading activity (buying and selling), which implies greater liquidity and market efficiency. Lower trade volume means less activity and low liquidity.

3. The size of the Crypto market

The size of the market in which one operates as a trader is also to be taken into account. Normally, the larger the market size, the more liquidity there is. However, it is also necessary to take into account the bag holders (accumulators of tokens). Indeed, if the majority of the outstanding tokens are held by a few whales (big holders) and they decide to enter the market without taking precautions, big price variations can take place and this can influence the current liquidity.

The size of the cryptocurrency market is, with each passing year, becoming more and more important. In fact, the combined market value of all crypto-currencies has surpassed the $1 trillion threshold for the first time since early November, according to CoinGecko, reaching $1020 billion.

Pockets of liquidity and Order Blocks

1. Pockets of liquidity: how to spot them?

Pockets of liquidity can be easily identified thanks to the concept of order blocks (OB) developed by ICT. These OBs correspond to price zones where there is a grouping of buy or sell orders of varying size from different players, with sufficient volume to temporarily turn the market around. Order Blocks can be represented on a chart by bid and ask zones in a very visual way. In addition, they allow to define precise entry points and invalidation points (see Stop Loss formation) that are easy to define. Essentially, pockets of liquidity or Order Blocks are the areas in which price is of great interest to clairvoyant traders. Within an Order Block, those who inject liquidity do so according to a plan designed to make profits in the medium or long term, which is why reactions to contact with these areas are particularly powerful.

2. How to define Order Blocks on a chart?

To do so, I invite you to read the chapter dedicated to Orders Blocks in my Price Action training.

The Fair Value Gap and the Liquidity Range Candle

Fair Value Gap : Definition

The Fair Value Gap (FVG) is one of the Smart Money Concepts developed by ICT. It is also known as Imbalance, Inefficiencies, or Liquidity Void, and identifies the largest Fair Value Gap during a past trading period. Often referred to as an institutional Fair Value Gap, these liquidity voids are primarily driven by institutions.

LVF’s are sudden price changes with a lack of liquidity. As soon as the price will tend to jump from the original price level to the final price level, creating an “imbalance” in the price.

The price tends to fill or retest the Fair Value Gap. This would allow traders to understand at what price level institutional players have been active. The FVG zone is a pretty serious concept. It provides insight into the price areas where many orders are placed.

There is an indicator on Tradingview that highlights the most significant Fair Value Gap or Imbalance on the chart and plots predicted future support and resistance levels based on the price action created at FVG. A super simple yet effective way to get solid market levels that act as a magnet for price.

Here are other indicators that find Imbalances. We can see here that the 3 indicators used (FVG, Imbalance Detector, Price Imbalance) highlight the same reality presented differently

Liquidity Range Candle | Liquidity Range Candle

The liquidity range candle is another trading concept used by large market players who keep the price within a specific market area, creating a narrow consolidation zone. When the price breaks through the liquidity range, liquidity flows into the market. This is an easy way to grab liquidity from retail traders (small individual traders). Stop losses are triggered, breakout traders jump into the market and institutional traders absorb the liquidity.

Warning: If you don’t see the liquidity, you become the liquidity!

The breakout of a liquidity range is a sign of breakout, potential continuation, retracement or reversal. Always use this signal in conjunction with an overall market analysis and price action. It is common for traders to also mark the previous 3 liquidity ranges and project them into the future. These empty areas can act as a future magnet for price, and a retest of them is very common. But if there is a breakout above/below a previous range, it can also be a sign of a trend change. We also know that these liquidity ranges have been important levels for institutional players, who may be willing to accumulate or distribute more orders at these levels (see Wyckoff method).

Kairos | Definition and Interpretation

The Kairos: moment when the conditions are met for the accomplishment of a crucial action; timely and decisive moment.

As a reminder, illiquid markets can become liquid, and liquid markets can become illiquid due to many different factors. It is critical to understand that this is a dynamic market, and even factors such as the time of day affect liquidity from asset to asset.

For example, with Bitcoin, we know that weekends are generally more illiquid than weekdays. We also know that there are times when liquidity can evaporate in both good and bad ways. If a FUD (Fear-Uncertainty-Doubt) item is released and people are suddenly less interested in buying all at once, buy-side liquidity will disappear. This can lead to a dramatic drop in price as all sellers unload into an empty order book.

The opposite can be said if the market is driven by FOMO (Fear Of Missing Out) and escapes, then sellers are no longer interested in current prices, and as their orders disappear, buyers drive prices up dramatically.

A good trader must therefore become aware of Kairos: he must come to feel, thanks to the daily and systematic analysis of the Price Action, which is the most opportune moment to trade and be able to avoid trading for the sake of trading, because “Knowing how to refrain from trading is also trading.” And this precept is also valid with regard to liquidity: no trade without liquidity.

Liquidity | Conclusion

Far from being exhaustive, we have tried, in this introduction, to make a global tour of the concept of liquidity widely used in trading. All the concepts described here, notably the FVG or the Block Order, do not come from me. As you know, the basis of my trading is the study of the Price Action. However, I do use some concepts from ICT that I find very relevant to explain some aspects of the development of AP. Moreover, ICT did not invent the powder, it created a new vocabulary from older concepts. Its merit remains perhaps to have synthesized and systematized them. Liquidity is one of the most important things to consider before participating in a market. A good trader must know how to evaluate signals that show changes in traded liquidity volumes and what they mean for his trades.