Our previous posts built a foundation to understanding cryptocurrency markets by defining markets, trades, and liquidity. However, even with this knowledge base, it’s still easy to misinterpret market signals and activity. To help everyone avoid basic errors, we’ve prepared this post to articulate and debunk some common misconceptions.
Misconception #1: There Is a Single Price of Bitcoin
When someone asks for the Bitcoin price, you might hear the answer “it depends.” This isn’t as strange as it sounds. For example, is there a single global price for a barrel of oil or gallon/litre of gas/petrol? Certainly not.
While deep and liquid exchanges such as Kraken operate globally, the overall market remains fragmented. A local exchange in one part of the world may offer a different Bitcoin price, at times within a few percentage points of each other, for reasons relating to local supply and demand dynamics. In fact, this is a common occurrence in cryptocurrency markets.
As a result, such price differences can lead to arbitrage, which is the practice of profiting from price differences of an asset across different markets by the simultaneous purchase and sale of the asset.
For a more in depth look at what it actually costs to buy and sell bitcoin, check out this post.
Misconception #2: High Volume Markets are Invulnerable to Slippage
A second misconception is that assets with high trading volume will never see significant price fluctuations. Trading volume is the total quantity of assets exchanged within a given time frame. An active market with high trading volume is typically, though not always, a market with a high number of bids and asks on offer at different prices.
This density could result in a narrower spread between a buyer’s bid and a seller’s ask for an asset. However, solely looking at past trading volume and spread of an asset of a market is not an accurate proxy for determining the support of an asset’s price.
Orderbook depth must be used to properly gauge how much volume can be supported within a given time frame before the market price of an asset begins to slip in either direction. Ask depth and bid depth showcase how much volume can be supported at each price point, and if the depth is shallow, a thin spread may not be enough to sustain a price.
Any order made in volumes greater than the volume of assets available at the current bid or ask will move the price, as all available quantity at current bid/ask levels will be absorbed by the order. This is also known as price slippage, the change in price during a trade where the volume of a placed order cannot be covered by existing orders of equal price and size, shifting execution to the next available price.
This could result in individuals entering (or exiting) a position at higher (or lower) than expected prices, because their market order moved the market by filling multiple ask (or bid) orders.
To illustrate, imagine there are 5 avocados sold at each dollar increment from a price range of $1.00-$2.00 per avocado. If a buyer orders 6 avocados from a farmer at market price, the buyer will purchase 5 from Merchant A who is offering 5 pieces at $1.00 each but 1 piece from Merchant B at $2.00, as all $1.00 avocados will have been taken.
In this scenario, no matter how many avocados have been sold previously, past sales alone will not guarantee that the current market price of avocados (asset price) will not slip to $2.00.
It is only when we look to the orderbook depth at each price point that we can predict how market prices will react to orders of a given size.
Misconception #3: Deep Orderbooks = Liquid Markets
Another common misconception is that a deep orderbook can serve as a proxy for market liquidity. We detailed the concept of liquidity in an earlier Market Series post, but for now it is enough to know that liquidity is a measure of an asset’s convertibility into its market value. An asset is said to be liquid if it can be quickly exchanged for (or near) its market value into another asset.
It is important to note that the depth of an orderbook alone is not indicative of the liquidity of a market, as we must look to bid-ask spread. Imagine an orderbook in a market having $1B worth of bids at $100 as best bid and $1B worth of asks at $900 as best ask. Despite the significant size of bid and ask orders in the orderbook, the volume is concentrated at polar opposite price points, creating a large bid-ask spread. This would make it difficult for participants to freely trade in this market without going to either price extreme, making the market highly illiquid.
Put more simply, think of it this way – you go to a farmer’s market to buy 5 avocados and you’re willing to pay $1.00 a piece. You learn that there are 10 avocados for sale, each at $10.00 a piece but you’re unable to purchase any as you’re unwilling to pay $10.00 for an avocado. Despite the available supply being satisfactory, this avocado market is illiquid.
Highly liquid markets are positioned to absorb a greater number and size of trade flow, and are likely to see less volatile price movements. Therefore, looking to the marketable depth – the liquidity close to fair market value – of an orderbook is a better method for determining market liquidity as it shows bid/ask size and thus the levels to which the market can support a given price range.
In reality, liquidity is fluid minute-by-minute, meaning traders could experience fluctuations in price resulting from evolving levels of liquidity.
So far in our markets series, we’ve laid the foundation for markets and orderbooks, defined a trade through different types of trade orders, explained liquidity, and in this post, explained common misunderstandings of the relationships between different variables in trading.
Our next, and final, post will show you how to spot bad markets, then provide a succinct summary on our entire markets series. Stick around, we’ve saved the best for last!
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