What Is Liquidity?

Liquidity measures how easily an asset can be bought or sold without changing its price. Highly liquid markets, like large stocks, let investors trade quickly near a stable price. Low liquidity, common in cryptocurrency markets, means fewer buyers and sellers are ready to trade, so the same news can swing prices much further and faster.

Liquidity & Volatility

The article defines volatility, explaining its role in financial markets and contrasting stable price movements with extreme price swings. It examines cryptocurrency markets, highlighting how limited liquidity and speculative news create unusually high volatility, which poses challenges for crypto as a stable currency.

What Is Volatility?

In any market, volatility is natural. Volatility in financial markets refers to changes in the price of an asset. Volatility can be healthy, with increases or decreases in price that are steady within a general range, however, it can also be extreme with dramatic price movements in either direction.

For those who see cryptocurrencies such as Bitcoin as the currency of the future, it should be noted that a currency needs stability so that merchants and consumers can determine what a fair price is for goods. Crypto prices are anything but stable. In other words, volatility is high.

Understanding Healthy Market Volatility

Extreme volatility has a negative connotation because many investors view volatility as synonymous market chaos, uncertainty, and losing money. An example of such extreme market volatility occurred during the 2008 Financial Crisis when traders — spooked by the specter of a collapse in global financial markets — causing financial markets to crash across the globe.

Fortunately, extreme price volatility is rare - in the stock market, at least. In the stock market, on a daily basis, volatility is moderate, or healthy volatility. With this type of volatility, price movements occur as investors and traders respond to information and news developments about companies, industries, and the broader macroeconomic sentiment.

Investors and traders assess market conditions and buy or sell assets accordingly, based on how they think the factors at play will affect prices.

Crypto Market Volatility

Most observers of cryptocurrency markets will agree that crypto volatility is in a different league altogether. One just needs to glance through historical price charts to see that skyrocketing peaks and depressive troughs occur at a quicker and more extreme pace in crypto prices compared to prices of assets in mainstream markets.

News developments and speculation are responsible for fueling price swings in crypto. But their effect is exaggerated in crypto markets as they have less liquidity than traditional financial markets. Heightened volatility and a lack of liquidity can create a dangerous combination because both feed off of each other.

There are signs that volatility in crypto markets is turning a corner. Institutional investors and trading firms are beginning to enter the asset class with more conviction.

The Future For Crypto

Whether crypto volatility will eventually mimic volatility patterns present in mainstream assets is unclear. Both healthy and unhealthy volatility create opportunities for profit. When stock prices change, this allows traders to buy low and sell high, or “short” a stock they expect to decrease in price.

Nonetheless as the asset class continues to grow and develop, it will likely continue to regularly exhibit outsized volatility until it reaches full maturity at some point in the future.

This price volatility creates a conundrum. If bitcoins might be worth a lot more in the future, people are less likely to spend and circulate them today, making them less viable as a currency. Why spend a bitcoin when it could be worth three times the value next year?

Key Takeaways

• Volatility in financial markets is completely natural and isn’t always a bad thing. The only time volatility becomes an issue is when it becomes very high as it can cause extreme price fluctuations in either direction for a stock price. Also having low volatility is crucial to being a method of transfer so sellers and buyers can agree on a price for goods. This is one of the issues Bitcoin is having now.
• Extreme volatility has a negative view as there is a lot of uncertainty when a good or stocks price is changing rapidly. This can cause investors to dump their shares due to fear of a rapid drop, which further increases the volatility as more investors dump/ buy shares.
• Fortunately, volatility in the stock market is extremely rare, however, in Crypto there is an insane amount of volatility. Looking at a chart of any major Cryptocurrency you can see the massive spikes and dips that have occurred. The reason for the massive volatility is that there is less liquidity in crypto markets.
• More large institutional investors are entering the crypto market and increasing liquidity in the markets; however, there is still uncertainty over whether crypto will ever have a similar volatility to the stock market.

Seeing Liquidity in Action

Liquidity is easiest to feel, not just define, by comparing two ends of the spectrum. A widely traded company has so many buyers and sellers active at once that a typical order barely moves the price at all. A newly listed or thinly traded asset works the opposite way: there might be only a handful of people willing to trade at any given moment, so one sizable order can push the price up or down noticeably before it fully fills.

This is worth watching in a hands-on financial literacy activity rather than just reading about it. Inside the Rapunzl investing simulator, which starts every student with a simulated $10,000 portfolio, it's possible to place an order in a heavily traded stock and watch it fill instantly near the price on screen, then compare that to an asset that trades less often and see the price move more before the order completes. Pulling up live market data alongside that trade makes the difference between a liquid and an illiquid market concrete instead of abstract.

That gap is exactly why crypto's volatility problem, covered in the article above, is really a liquidity problem wearing a different name.

This explainer comes from Module 26 of the Rapunzl curriculum. Teachers: the accompanying activity and answer key are in the teacher portal.