A lot of people find crypto trading very different, strange, and scary compared to traditional markets, and that’s understandable because the market behaves very differently. But if you deeply grasp the underlying principles behind markets, you’ll understand that the oddities have fundamentally sound explanations.

So what does a successful professional crypto trader comprehend and consider that others do not? Liquidity.

Understanding liquidity helps explain a lot of the oddities around crypto market behavior, particularly the drastic price swings that are prevalent in the space.

What is liquidity?

Liquidity represents the ability for someone to convert an asset into cash without impacting its price. One way to measure liquidity is the amount of time required to sell a specified amount of an asset without moving its price.

For example, a house has very low liquidity because of its uniqueness (in both its geographic location as well as its construction); usually it takes a few months for a house to sell. On the other hand, Apple stock has relatively high liquidity because its shares are completely fungible and there are many buyers and sellers concentrated in a single marketplace (the NASDAQ exchange) with very high transaction volume occuring daily.

Why don’t people understand crypto liquidity?

I think people are used to the deep liquidity provided by traditional financial markets; let’s go over the differences between liquidity in the equities vs crypto markets:

Equities

  • Listing: Listing on an exchange requires significant market cap; lots of legal preparation and compliance, so only deep pocketed firms can afford this process.
  • Float: Shares of a company that are traded are known to be issued; share dilution is generally infrequent and well advertised ahead of time.
  • Concentration: Shares of a company are all traded on a single or at most 2-3 venues (i.e. NASDAQ, BATS, ARCA, etc.) and within a single national boundary, all of which helps to concentrate the liquidity.
  • Hours: Trading hours are limited (9:30am - 4pm EST) so that market participants can digest news and (theroetically) plan for more long term decisions.
  • Settlement: Upon a trade, settlement usually takes 3+ days.
  • Distribution: Shares of a public company are generally relatively widely distributed, meaning that there’s many shareholders.
  • Circuit Breakers: In the event of a large price movement, there are established procedures called “Market Wide Circuit Breakers” that halt trading temporarily or prematurely close the impacted market to curb panic selling or FOMO buying.

Crypto

  • Listing: Any market cap can be listed and traded on a decentralized exchange like Uniswap; literally just requires depositing the token onto the decentralized exchange.
  • Float: Some tokens might be locked (via social or smart contracts) or even not issued yet, and the rate of issuance may change. Tokens may be burned or lost. Generally this information is technically transparent and available on-chain, but it may be difficult for non-crypto natives to know where to look and interpret the information.
  • Concentration: Tokens may be tradeable on a wide variety of dozens of centralized and decentralized exchanges internationally in addition to the possibility of peer to peer transfers.
  • Hours: Trading happens 24/7 and market participants tend to react immediately to news events at all hours.
  • Settlement: Upon a trade, both parties receive their respective tokens immediately, allowing the next holder to immediately transact as well.
  • Distribution: The token distribution for a project could potentially be very concentrated to just a few “whales” who own the majority of the float.
  • Circuit Breakers: There are no procedures to halt trading during periods of severe price volatility on either centralized nor decentralized exchanges.

I believe these lists help to showcase the fact that traditional markets have a wide array of functionality that was specifically architected to ensure deep pools of liquidity, and so as a result people are accustomed to always accessing that level of liquidity and assume that the corresponding market behavior of deeply liquid markets should apply to thin markets as well, which is unfortunately not true.

Cryptocurrency project tokens do not have any of those requirements, and so as a result the market behavior differs wildly, especially for smaller/earlier projects (which not coincidentally have the potential for the biggest gains). As a result, those without experience in thinly traded markets immediately assume there are nefarious actors or that the system is rigged when in fact the observed behavior is merely a manifestation of the different market conditions with less liquidity - ITLiqs!

What opportunities suddenly arise if you pay attention to liquidity?

Here’s one cool trick I love to use if I am looking to dollar cost average into any cryptocurrency; I know that because of the relatively lighter liquidity, the volatility is higher, so based on the liquidity that I see, I’m personally comfortable to place passive orders relatively far away from the current market price in order to get a discount on my entry.

What that means is if I want to buy Bitcoin, and the current price is $40,000, then depending on what I’m seeing in the liquidity of the current venue I’m trading on, I’ll put a BUY order for $39,500 with relative confidence that my order will be filled.

For less liquid tokens I’m comfortable placing even further away because I believe that due to the lighter liquidity there will be more price fluctuations.

This is an easy way to accumulate more crypto at a cheaper cost basis if you have a long term outlook and aren’t FOMO’ing into a position.

The additional benefit is that on many exchanges, placing passive orders also reduces the fees that you pay since you’re adding liquidity to their order book, so you save a little more on fees as well!

Conclusion

Hopefully this was a helpful primer in explaining liquidity and its role in markets.

If you keep in mind ITLiqs, applying the fundamental concept of liquidity to the crypto markets will help you make sense of its behavior and even potentially give you some predictive capabilities or at least a different way of evaluating how to participate in the markets.