Bitcoin Trading Guides

The Importance of Liquidity and Volume in Trading Bitcoin

In the YouTube video, “Crypto Investing #2 – How to Use Volume & Liquidity When Trading Cryptocurrencies,” Tai Zen, CEO and senior technical analyst for Cryptocurrency Market, points out the importance of volume and liquidity in altcoin trading.

What is Liquidity?

In financial markets, liquidity is the ease with which an asset or security can be bought without affecting the price. In a situation where demand outpaces supply, the asking price can grow out of control and outpace bidding prices, creating a large spread. This is a bad situation for buyers, as the ability to buy at or near the bidding price is compromised in these situations.

The best way to think about this is to imagine a buyer who seeks to purchase a rare car. The car costs $35,000. The buyer, however, only has $7,500 at hand. However, he has a rare comic books collection that he is willing to part with for $30,000. In the town in which he lives, there is only one comic books buyer, and he is only interested in our would-be car buyer’s collection for $20,000.

In this low demand/low supply situation, the market is illiquid and there is a wide spread between the asking and bidding price. Our would-be car buyer’s price is in a weak position because he has a need to sell to the only available buyer in the market. Likely, his ask price will need to drop to get a buy.

Conversely, the would-be comic books buyer is in a strong position; he does not have to buy right now and he can wait the seller out. His bid price may have to rise, but not nearly by the same amount the ask price will have to drop.

In a widespread market, prices can fluctuate wildly. Should we reverse our example and make it a “high demand/low supply” situation, with the comic books dealer seeking out our would-be car buyer, the buy price could be very close to, or even exceed, the original ask price.

The most liquid asset is fiat currency or cash. An asset’s liquidity is typically measured with cash or cash equivalents as a benchmark. The most illiquid asset currently is real estate, which could take weeks or months to sell. Our example approaches real estate in its degree of illiquidity.

However, if our would-be car buyer decided to sell his collection online to a comic books collector community, the liquidity of the market would improve. He would be more likely to sell his comic books quickly at the price he seeks.

Trading Bitcoin

What About Volume?

In altcoin trading, it is essential to trade in assets that have high liquidity. High-liquidity assets, such as bitcoin and ethereum, typically have high daily trading volumes. Buying in these markets will help you to control your buying price.

As an example in the video, Zen used Dogecoin. Popular as a Reddit tipping currency, this one-time “joke altcoin” now has a market capitalization of $357 million, with a daily trading volume (as of June 4, 2017) of $34 million. This pales compared to bitcoin, which is at $42 billion and $1.3 billion, respectively.

Dogecoin has suffered recently from a lack of interest, with the daily trading volume hitting a low of $67,000 just four months ago. If someone had bought a large order of dogecoin at that time, it would be unlikely that the order could be placed with just one buyer. The buyer would get a fraction of the dogecoins at his bid price, but when seeking additional buyers to complete his order, he would find that his previous large buy caused a rise in asking prices across the market. This lack of volume turned Dogecoin illiquid and unattractive for the price-sensitive altcoin trader.

Understanding volume and liquidity is essential to not only understand altcoin pricing, but to avoid pricing traps in the market. Knowing how to “play the market” is the first step to becoming a successful investor who can understand and predict the market to maximum effect.

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