Liquidity refers to the ease with which you’re able to trade an asset without affecting its price based on factors such as supply and demand.
In real-world terms, assets such as houses and cars can be categorized as illiquid assets, because the sale of these assets requires time, effort, paperwork, and sourcing buyers - making them more difficult to exchange.
Speculative markets operate according to this same principle:
- If an asset has high trading volume, there’s significant demand to trade it by willing buyers and sellers on an order book, and it can thus be considered liquid;
- However, if there is very low volume and the order book is sparsely populated, meaning that there’s insufficient demand (bids) for assets you wish to sell, or insufficient supply (asks) for assets you wish to buy, an asset can be rendered illiquid as it becomes difficult to trade.
Understanding slippage
Liquidity and slippage go hand in hand. While liquidity refers to the volume of orders in the orderbook, slippage refers to the difference between the quoted market price and the closest available order price at which an asset can actually be traded for a certain volume.
When a trading pair is liquid, it should trade for large volume, close to the quoted market price.
- Alice wants to buy 1 unit of ABC at a price of R1,000;
- If the pair is liquid, her bid (buy) will be easily matched with an ask (sell) at R1,000;
- As there are many orders near her price point, she’s able to buy 1 ABC for R1,000;
- In this case, Alice incurs 0% slippage.
Conversely, when there’s low volume and a lack of liquidity on the order book, slippage may be high.
- Alice wants to buy 1 unit of ABC at a price of R1,000;
- Her bid (buy) will be matched with the closest ask (sell) which could be far higher than the quoted market price if the pair is not liquid
- In this example, the closest sell order is at a price of R2,000
- As a result, Alice only receives 0.5 ABC for her R1,000
In the example above, Alice has incurred 50% slippage - she has only been able to buy 0.5 ABC for the price at which she attempted to buy 1 ABC.