The definition of the term liquidity is: the ability to buy or sell an asset in the market without causing drastic changes in the price of the asset in the market.

Liquidity can refer to two distinct areas; liquid markets and liquid assets.

Liquid markets mean that there are always investors willing to trade in the market, and liquid assets are assets that can be easily converted into cash.

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But what does this concept mean in the cryptocurrency space?

As with any investment, you want to be able to buy and sell tokens quickly without having to drop prices or wait for trades to match. In order to achieve this, the market in which transactions are conducted must be liquid. In other words, there must be active trading activity in the market, and the buying and selling prices cannot be too far apart.

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Let’s take an example from a seller’s perspective:

Bob owns 5 of a certain cryptocurrency and the price of his token has increased over the past few days. Bob is happy and decides to quickly sell all his tokens at the current market price.

If the market is liquid, that is, there are enough buyers willing to buy Bob’s tokens at the price he wants, Bob can quickly sell the asset at the price he wants. Since there is enough liquidity (in the market) to accommodate Bob’s transaction, his transaction will not affect the price of the token.

However, if Bob asks to sell his 5 tokens at the current market price in an illiquid market, there will not be enough buyers willing to pay Bob’s asked price and he will need to lower his asking price or wait for the market become more liquid in order to sell his tokens. If Bob decides to sell at a lower price, his transaction will also affect the current market price of this token.

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How to tell if the market is liquid

When considering whether a market is liquid, it is good practice to first look at three important metrics: 24-hour volume, order depth, and the difference between the ask price and the bid price, also known as the bid-ask spread.

However, due to factors such as limit stop orders and iceberg orders, the order book does not represent the most accurate price. These special orders are created through trade automation tools and therefore do not necessarily appear on the order book until certain conditions are met.

Liquidity is extremely important when considering trading. This is a key factor in the ease of entering or exiting the market.

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