Lesson 4: Spread and Liquidity

As already mentioned in the lessons on limit and market orders, the spread is the difference between the bid price (the highest buy price) and the ask price (the lowest sell price).
This lesson will dive into how the spread reflects market liquidity, and how order volumes and volatility affect it.

Narrow spread: A narrow spread on a market such as Bitcoin points to high liquidity.
In that case a large number of buyers and sellers are ready to trade at prices close to the current price, which lowers trading costs and makes it easier to enter and exit a position.
It also means there are enough limit orders at different levels, which help keep the price stable. 
Densely placed bid and ask orders reduce the risk of sharp price swings when market orders are executed.
Market orders find matching limit orders faster, which helps trades execute with minimal price change.

Wide spread: When the spread on Bitcoin widens, it points to low liquidity or high volatility.
For example, during a sharp drop or rise in Bitcoin's price the spread can widen significantly, which increases risk for traders because of the larger gap between bid and ask prices.
This happens because of the influence of market and limit orders: market orders, especially large ones, can absorb the available limit orders at different levels, which speeds up the price change. At the same time, if the bids or asks are not dense enough, each market order can put even more pressure on the price, causing the spread to widen.

Liquidity is the ability of an asset, such as bitcoin, to be bought or sold quickly at the current market price without significant price changes.

 

Liquid market: On an exchange with high bitcoin trading volume, such as Binance or Coinbase, buying or selling large amounts usually has minimal impact on the price, because there are always enough opposing orders. For example, a large market buy order is filled quickly at the current ask price without significant shifts.

 

Illiquid market: On less liquid platforms, or with low trading volume assets such as a rare altcoin, even a small trade can cause a strong price change, because there may not be enough opposing orders. For example, a market buy order can absorb several ask levels, which sharply pushes the asset's price up.

Let's check how well you've learned the material from this lesson. Answer the questions to test your knowledge and move on to the next lesson.

In this lesson we learned to determine the spread between the bid and ask prices, understand its impact on market liquidity and trading costs, and tell liquid markets from illiquid ones, understanding how this affects the asset's price and the risks for traders.