Liquidity is a measure of your ability to cheaply buy or sell an asset without causing significant price movement. Sufficient liquidity is an integral component of a well-functioning market.
How do you measure liquidity in an Orderbook?
As mentioned, for a market to be liquid it needs to be able to absorb large orders with little price impact. This depends on two factors:
- Bid-Ask Spreads
- Order Book Depth
Bid-Ask Spreads are the difference between the highest offer to buy (bid) and the lowest offer to sell (ask) in a market. The bid-ask spread is a reliable sign of market liquidity, with tighter spreads indicating high liquidity and wider spreads indicating low liquidity.
In liquid markets, there are many traders, leading to higher volumes, which in turn keeps the bid and ask prices very close together. A smaller spread also means that trading costs are lower, as the cost of buying at the ask price and selling at the bid price is minimized.
On the other hand, when there are fewer traders and volume, bid and ask prices can diverge significantly. This also increases the cost of trading, as traders may have to pay a premium to purchase an asset, and sellers may have to accept a discount.
Order Book depth is another important measure of market liquidity. The orderbook lists all the orders in the market for a specific asset. The depth of the order book represents the quantity of the asset that can be bought or sold at different price levels.
A deep orderbook is indicative of liquidity. In a deep market, there are numerous and sizeable orders at each price point, allowing for large trades to occur without causing a significant impact on the price, and offering more opportunities for traders to enter or exit positions.
Conversely, a shallow order book represents a low level of liquidity. In such a market, there are fewer orders at each price level, meaning large trades can cause considerable price movements. The lack of depth can also make it harder for traders to enter or exit positions.
Measuring liquidity is very important for traders of long tail assets (which are less liquid) and for whales whose orders can have a big impact on price. Lets see an example on how this works:
A user wants to sell 10 ETH at market price and he has two markets to choose from, both with a ETH price of $2000
- Market 1 has an order to buy 10 ETH at $2000
- Market 2 has an order to buy 5 ETH at $2000 and 5 ETH at $1900
All other things equal, where should the user sell?
The user would benefit from offloading the ETH in Market 1 as the orderbook can instantly absorb his order.
If he were to sell in Market 2 it would suffer from slippage, selling 5 at $2000 and 5 at $1900, resulting in an average sell price of $1950.
